-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, U3t5PjPG7K4MwxH0kRlnJGsbX4wrdfuwlpgeRtMPGzOh1BoypfzED5EQgnuO+iTE +oNX8B5Zr2hR5jxw+qpRrA== 0000702902-06-000063.txt : 20061108 0000702902-06-000063.hdr.sgml : 20061108 20061108153049 ACCESSION NUMBER: 0000702902-06-000063 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20060930 FILED AS OF DATE: 20061108 DATE AS OF CHANGE: 20061108 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HARLEYSVILLE NATIONAL CORP CENTRAL INDEX KEY: 0000702902 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 232210237 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-15237 FILM NUMBER: 061197265 BUSINESS ADDRESS: STREET 1: 483 MAIN ST STREET 2: P O BOX 195 CITY: HARLEYSVILLE STATE: PA ZIP: 19438 BUSINESS PHONE: 2152568851 MAIL ADDRESS: STREET 1: 483 MAIN STREET CITY: HARLEYSVILLE STATE: PA ZIP: 19438 10-Q 1 form10q-3rdqtr906.htm FORM 10Q FOR HARLEYSVILLE NATIONAL CORP. 3RD QUARTER ENDED SEPTEMBER 30, 2006 Form 10Q for Harleysville National Corp. 3rd Quarter Ended September 30, 2006

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

___________________

Form 10-Q
__________________

x   Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended September 30, 2006

Or

¨   Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the transition period from ___________ to __________

Commission file number 0-15237

___________________

HARLEYSVILLE NATIONAL CORPORATION
(Exact name of registrant as specified in its charter)

___________________

 
Pennsylvania
  
23-2210237
(State or other jurisdiction
of incorporation or organization)
  
(IRS Employer
Identification No.)

483 Main Street
Harleysville, Pennsylvania 19438
(Address of principal executive office and zip code)

(215) 256-8851
(Registrant’s telephone number, including area code)

___________________

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨ 
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). 
Large accelerated filer o Accelerated filer x Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 28,960,133 shares of Common Stock, $1.00 par value, outstanding on November 3, 2006.

-1-


HARLEYSVILLE NATIONAL CORPORATION
  
   
   
INDEX TO FORM 10-Q REPORT
  
   
 
PAGE
   
Part I. Financial Information
  
   
Item 1. Financial Statements:
  
   
Consolidated Balance Sheets at September 30, 2006 (unaudited) and December 31, 2005
3
   
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2006 and 2005 (unaudited)
4
   
Consolidated Statements of Shareholders’ Equity for the Nine Months Ended September 30, 2006 and 2005 (unaudited)
5
   
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005 (unaudited)
6
   
Notes to Consolidated Financial Statements
7
   
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
17
   
Item 3. Quantitative and Qualitative Disclosures about Market Risk
30
   
Item 4. Controls and Procedures
30
   
Part II. Other Information
31
   
Item 1. Legal Proceedings
31
   
Item 1A. Risk Factors
31
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
31
   
Item 3. Defaults Upon Senior Securities
31
   
Item 4. Submission of Matters to a Vote of Security Holders
31
   
Item 5. Other Information
31
   
Item 6. Exhibits
31
   
Signatures
32

 
-2-

PART 1. FINANCIAL INFORMATION
  
HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
  
CONSOLIDATED BALANCE SHEETS
  
   
(Dollars in thousands)
   
September 30, 2006
    
December 31, 2005
 
 
    
(Unaudited) 
        
Assets
              
Cash and due from banks
  
$
62,909
  
$
57,756
  
Federal funds sold and securities purchased under agreements to resell
    
176,500
    
35,000
 
Interest-bearing deposits in banks
    
3,463
    
2,455
 
Total cash and cash equivalents
    
242,872
    
95,211
  
Residential mortgage loans held for sale
    
1,125
    
2,028
  
Investment securities available for sale
    
863,357
   
841,653
  
Investment securities held to maturity (market value $59,301 and $59,753, respectively)
    
58,894
   
59,555
  
Loans and leases
    
2,033,148
    
1,983,465
 
Less: Allowance for loan losses
    
(21,303
)
  
(19,865
)
Net loans
    
2,011,845
   
1,963,600
 
Premises and equipment, net
    
33,269
   
27,570
 
Accrued interest receivable
    
14,894
   
13,282
 
Goodwill
    
42,956
   
31,552
  
Intangible assets, net
    
7,434
    
4,031
 
Bank-owned life insurance
    
61,125
   
59,334
 
Other assets
    
25,232
   
19,543
 
Total assets
  
$
3,363,003
  
$
3,117,359
  
Liabilities and Shareholders' Equity
              
Deposits:
              
Noninterest-bearing
  
$
326,851
  
$
363,440
  
Interest-bearing:
              
Checking accounts
    
571,444
   
387,374
 
Money market accounts
    
675,904
   
667,952
  
Savings
    
150,889
   
190,033
 
Time deposits
    
903,158
   
756,658
 
Total deposits
    
2,628,246
   
2,365,457
 
Federal funds purchased and securities sold under agreements to repurchase
    
113,086
    
88,118
  
Other short-term borrowings
    
1,438
    
1,752
  
Long-term borrowings
    
239,750
   
297,750
  
Accrued interest payable
    
29,123
   
28,276
 
Subordinated debt
    
51,548
   
51,548
  
Other liabilities
    
13,207
   
11,226
 
Total liabilities
    
3,076,398
   
2,844,127
 
Shareholders' Equity:
              
Series preferred stock, par value $1 per share;
    
   
 
Authorized 8,000,000 shares, none issued
    
-
    
-
 
Common stock, par value $1 per share; authorized 75,000,000
    
   
 
shares; issued 29,074,250 shares at September 30, 2006 and
              
27,500,407 shares at December 31, 2005
    
29,074
    
27,500
 
Additional paid in capital
    
194,818
    
167,418
  
Retained earnings
    
71,860
    
88,285
 
Accumulated other comprehensive loss
    
(7,300
)
  
(8,618
)
Treasury stock, at cost: 90,550 shares at September 30, 2006 and
             
64,700 shares at December 31, 2005
    
(1,847
)
  
(1,353
)
Total shareholders' equity
    
286,605
   
273,232
 
Total liabilities and shareholders' equity
  
$
3,363,003
  
$
3,117,359
  
See accompanying notes to consolidated financial statements.

-3-
 

 
HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
 
  
Three Months Ended 
Nine Months Ended
 
September 30, 
September 30,
(Dollars in thousands, except per share information)
    
2006
 
 
2005
 
 
2006
 
 
2005
  
                           
Interest Income:
                          
Loans and leases, including fees
  
$
34,553
  
$
29,677
  
$
99,519
  
$
83,899
  
Investment securities:
                          
Taxable
    
7,538
    
5,678
   
22,412
    
17,362
  
Exempt from federal taxes
    
2,643
    
2,797
    
7,842
    
8,476
  
Federal funds sold and securities purchased under agreements to resell
    
1,182
    
353
    
2,363
    
888
  
Deposits in banks
    
45
    
65
    
144
    
106
  
Total interest income
    
45,961
    
38,570
   
132,280
    
110,731
  
                           
Interest Expense:
                          
Savings and money market deposits
    
10,630
    
5,916
   
27,061
    
15,235
  
Time deposits
    
9,732
    
6,163
    
26,341
    
17,130
  
Short-term borrowings
    
1,385
    
1,299
    
3,889
    
3,153
  
Long-term borrowings
    
3,600
    
3,448
   
11,628
    
9,952
 
Total interest expense
    
25,347
    
16,826
    
68,919
    
45,470
  
                           
Net interest income
    
20,614
    
21,744
   
63,361
    
65,261
 
Provision for loan losses
    
900
    
650
    
3,000
    
2,050
  
Net interest income after provision for loan losses
    
19,714
    
21,094
    
60,361
    
63,211
 
                           
Noninterest Income:
                          
Service charges
    
2,092
    
2,112
    
6,008
    
6,113
  
Gain on sales in investment securities, net
    
-
    
1,898
    
-
    
3,047
  
Gain on sale of credit card portfolio
    
-
    
-
    
1,444
    
-
  
Gain on sale of branch
    
-
    
-
    
-
    
690
  
Wealth management income
    
3,372
    
1,261
   
11,224
    
5,241
  
Bank-owned life insurance income
    
591
    
497
   
1,792
    
1,635
  
Other income
    
2,231
    
1,962
   
6,771
    
5,699
 
Total noninterest income
    
8,286
    
7,730
   
27,239
    
22,425
  
Net interest income after provision for loan losses and
                         
noninterest income
    
28,000
    
28,824
   
87,600
    
85,636
  
                           
Noninterest Expense:
                          
Salaries, wages and employee benefits
    
11,487
    
9,189
    
32,860
    
28,869
  
Occupancy
    
1,379
    
1,277
   
4,278
    
3,911
  
Furniture and equipment
    
917
    
963
    
2,708
    
3,284
 
Marketing
    
493
    
617
    
1,422
    
2,018
  
Other expense
    
3,284
    
3,267
   
11,192
    
9,627
 
Total noninterest expense
    
17,560
    
15,313
   
52,460
    
47,709
 
                           
Income before income tax expense
    
10,440
    
13,511
   
35,140
    
37,927
 
Income tax expense
    
2,533
    
3,349
   
8,997
    
8,910
 
Net income
  
$
7,907
  
$
10,162
  
$
26,143
  
$
29,017
  
                           
Net income per share information:
                          
Basic
  
$
0.27
  
$
0.35
  
$
0.90
  
$
1.00
  
Diluted
  
$
0.27
  
$
0.34
  
$
0.89
  
$
0.98
  
Cash dividends per share
  
$
0.19
  
$
0.17
  
$
0.55
  
$
0.50
  
Weighted average number of common shares:
                          
Basic
    
29,011,903
    
28,897,869
   
28,940,119
    
28,921,613
 
Diluted
    
29,384,310
    
29,479,228
    
29,373,646
    
29,541,486
  
                           
See accompanying notes to consolidated financial statements.

-4-
 
 
HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Unaudited)
(Dollars and share information in thousands)


Nine Months Ended September 30, 2006
                                                         
 
                                                        
 
    
Common Stock 
    
Treasury Stock
          
 
          
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of
 
 
Number of
 
 
Par
 
 
Additional Paid
 
 
Retained
 
 
Accumulated Other Comprehensive
 
 
Treasury
 
 
 
 
 
Comprehensive
 
 
 
 
Shares  
 
 
Shares
 
 
Value
 
 
In Capital
 
 
Earnings
 
 
Income (Loss)
 
 
Stock
 
 
Total
 
 
Income
 
                                                         
Balance, January 1, 2006
    
27,500
    
(64
)
$
27,500
  
$
167,418
  
$
88,285
  
$
(8,618
)
$
(1,353
)
$
273,232
        
Issuance of stock for stock options, net
of excess tax benefits
    
192
    
193
    
192
    
1,862
    
-
    
-
    
4,020
    
6,074
        
Issuance of stock for stock awards
    
-
    
-
    
-
    
5
    
-
    
-
    
-
    
5
        
Stock based compensation expense
    
-
    
-
    
-
    
345
    
-
    
-
    
-
    
345
        
Stock dividend
    
1,382
    
-
    
1,382
    
25,188
    
(26,582
)
  
-
    
-
    
(12
)
      
Net income
    
-
    
-
    
-
    
-
    
26,143
    
-
    
-
    
26,143
  
$
26,143
  
Other comprehensive income, net of reclassifications and tax
    
-
    
-
    
-
    
-
    
-
    
1,318
    
-
    
1,318
    
1,318
  
Purchases of treasury stock
    
-
    
(219
)
  
-
    
-
    
-
    
-
    
(4,514
)
  
(4,514
)
      
Cash dividends
    
-
    
-
    
-
    
-
    
(15,986
)
  
-
    
-
    
(15,986
)
      
Comprehensive income
                                                  
$
27,461
  
Balance, September 30, 2006
    
29,074
    
(90
)
$
29,074
  
$
194,818
  
$
71,860
  
$
( 7,300
)
$
(1,847
)
$
286,605
        
                                                         




Nine Months Ended September 30, 2005
  
                                       
                                                       
 
    
Common Stock 
 
 
Treasury Stock
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of 
 
 
Number of
 
 
Par
 
 
Additional Paid
 
 
Retained
 
 
Accumulated Other Comprehensive
 
 
Treasury
 
 
 
 
 
Comprehensive
 
 
 
 
Shares 
 
 
Shares
 
 
Value
 
 
In Capital
 
 
Earnings
 
 
Income (Loss
)
 
Stock
 
 
Total
 
 
Income (Loss
)
                                                         
Balance, January 1, 2005
    
27,320
    
(1,043
)
$
27,320
  
$
160,039
  
$
99,730
  
$
1,243
  
$
(17,800
)
$
270,532
        
Issuance of stock for stock options, net
of tax benefits
    
142
    
68
    
142
    
2,181
    
-
    
-
    
1,282
    
3,605
        
Issuance of stock for stock awards
    
-
    
-
    
-
    
5
    
-
    
-
    
-
    
5
        
Stock dividend
    
38
    
1,272
    
38
    
6,090
    
(29,535
)
  
-
    
23,392
    
(15
)
      
Net income
    
--
    
-
    
-
    
-
    
29,017
    
-
    
-
    
29,017
  
$
29,017
  
Other comprehensive loss, net of reclassifications and tax
    
-
    
-
    
-
    
-
    
-
    
(5,345
)
  
-
    
(5,345
)
  
(5,345
)
Purchases of treasury stock
    
-
    
(338
)
  
-
    
-
    
-
    
-
    
(7,743
)
  
(7,743
)
      
Cash dividends
    
-
    
-
    
-
    
-
    
(14,429
)
  
-
    
-
    
(14,429
)
      
Comprehensive income
                                                  
$
23,672
  
Balance, September 30, 2005
    
27,500
    
(41
)
$
27,500
  
$
168,315
  
$
84,783
  
$
(4,102
)
$
(869
)
$
275,627
        
                                                         
 
                                                 
See accompanying notes to consolidated financial statements.


-5-


HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
  
Nine Months Ended  
(Dollars in thousands)
  
September 30,
     
2006
    
2005
  
Operating Activities:
              
Net income
  
$
26,143
  
$
29,017
  
Adjustments to reconcile net income to net cash provided by operating activities:
    
       
Provision for loan losses
    
3,000
    
2,050
  
Depreciation and amortization
    
3,324
    
2,352
  
Net amortization of investment securities discounts/premiums
    
2,711
   
2,126
  
Deferred income tax benefit
    
(2,120
)
  
(2,892
)
Gains on sales of investment securities, net
    
—
    
(3,047
)
Gain on sale of credit card portfolio
    
(1,444
)
  
—
  
Gain on sale of branch
    
—
    
(690
)
Gain on sale of bank subsidiary
    
—
    
(287
)
Bank-owned life insurance income
    
(1,792
)
  
(1,635
)
Stock based compensation expense
    
345
    
—
  
Net increase in accrued interest receivable
    
(1,612
)
  
(642
)
Net increase (decrease) in accrued interest payable
   
847
    
(1,894
)
Net (increase) decrease in other assets
   
372
    
(2,380
)
Net decrease in other liabilities
    
(3,631
)
  
(2,598
)
Other, net
    
(88
)
  
(9
)
   Net cash provided by operating activities
   
26,055
   
19,471
    
 
  
Investing Activities:
              
Proceeds from sales of investment securities available for sale
    
—
    
247,040
    
 
  
Proceeds from maturity or calls of investment securities held to maturity
    
617
    
5,870
  
Proceeds from maturity or calls of investment securities available for sale
    
121,486
    
144,473
  
Purchases of investment securities available for sale
    
(143,821
)
  
(362,435
)
Net increase in loans
    
(65,693
)
  
(102,787
)
Net cash paid due to acquisition, net of cash acquired
    
(14,525
)
  
—
  
Net proceeds from sale of credit card portfolio
    
16,705
    
—
  
Net cash paid in sale of branch
    
—
    
(7,431
)
Net cash received from sale of bank subsidiary
    
—
    
1,931
  
Purchases of premises and equipment
   
(8,241
)
  
(2,563
)
Proceeds from sales of premises and equipment
   
216
    
42
  
Purchase of bank-owned life insurance
    
—
    
(5,000
)
Proceeds from sales of other real estate
   
32
    
142
  
    Net cash provided used in investing activities
   
(93,224
)
  
(80,718
)
Financing Activities:
              
Net increase in deposits
   
262,789
    
150,574
  
Increase (decrease) in federal funds purchased and securities sold under agreements to repurchase
    
24,968
    
(37,954
)
Decrease in short-term borrowings
    
(314
)
  
(45,507
)
Advances of long-term borrowings
    
10,000
    
20,000
  
Repayments of long-term borrowings
    
(68,000
)
  
—
  
Advances of subordinated debt
    
—
    
25,774
  
Cash dividends
    
(15,986
)
  
(14,429
)
Repurchase of common stock
    
(4,514
)
  
(7,743
)
Proceeds from the exercise of stock options
   
5,032
    
3,605
 
Excess tax benefits from stock based compensation
   
867
    
—
  
Other, net
    
(12
)
  
(15
)
Net cash provided by financing activities
   
214,830
    
94,305
  
Net increase in cash and cash equivalents
    
147,661
    
33,058
  
Cash and cash equivalents at beginning of period
    
95,211
    
106,990
  
Cash and cash equivalents at end of the period
  
$
242,872
  
$
140,048
  
               
Cash paid during the period for:
              
Interest
 
$
42,790
  
$
47,611
  
Income taxes
  
$
12,173
  
$
13,018
  
Supplemental disclosure of noncash investing and financing activities:
              
Transfer of assets from loans to net assets in foreclosure
 
$
114
  
$
279
  
 
See accompanying notes to consolidated financial statements.
              

-6-


HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies

Principles of Consolidation and Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the consolidated financial position of Harleysville National Corporation (the Corporation) and its wholly owned subsidiaries - Harleysville National Bank (the Bank), HNC Financial Company and HNC Reinsurance Company, as of September 30, 2006, the results of its operations for the three and nine month periods ended September 30, 2006 and 2005 and the cash flows for the nine month period ended September 30, 2006 and 2005. The Cornerstone Companies’ (subsidiaries of the Bank) results of operations are included in the Corporation’s results beginning January 1, 2006 through September 30, 2006. Certain prior period amounts have been reclassified to conform to current year presentation. All significant intercompany accounts and transactions have been eliminated in consolidation. We recommend that you read these unaudited consolidated financial statements in conjunction with the audited consolidated financial statements of the Corporation and the accompanying notes in the Corporation's 2005 Annual Report on Form 10-K. The results of operations for the three and nine month periods ended September 30, 2006 and 2005 are not necessarily indicative of the results to be expected for the full year.

 The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Actual results could differ from those estimates.

Goodwill and Other Intangible Assets

Goodwill and identifiable intangibles were $43.0 million and $3.6 million, respectively at September 30, 2006, and $31.6 million and $0, respectively at December 31, 2005. In January 2006, the Corporation completed the acquisition of the Cornerstone Companies including $11.4 million of goodwill and $3.9 million of identifiable intangibles (with a weighted average amortization period of 9.3 years) allocated to the Wealth Management segment. The amortization of the identifiable intangibles related to the Wealth Management segment totaled $114,000 for the third quarter of 2006 and $336,000 for the first nine months of 2006. Amortization of other intangible assets, primarily core deposit intangible, allocated to the Community Banking segment were $62,000 for both the three months ended September 30, 2006 and 2005 and $185,000 for both the nine months ended September 30, 2006 and 2005. Management performed its annual review of goodwill at June 30, 2006 in accordance with SFAS No. 142 and determined there was no impairment of goodwill and identifiable intangible assets.

Stock Based Compensation

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)). SFAS 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services and addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS 123(R) focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. Under SFAS 123(R), all forms of share-based payments to employees, including employee stock options, are treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award is generally measured at fair value at the grant date with compensation expense recognized over the service period, which is usually the vesting period. SFAS 123 required that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements. SFAS 123(R) eliminates the ability to account for share-based compensation transactions using APB 25.

The Corporation adopted SFAS No. 123(R) on January 1, 2006 using the modified prospective application method of transition. Prior to January 1, 2006, the Corporation followed APB 25 and the disclosure requirements of FAS 123(R) with pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS 123 had been applied. The Corporation’s consolidated financial statements as of September 30, 2006 and for the first nine months of 2006 reflect the impact of adopting FAS 123(R). In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of FAS 123(R). Effective January 1, 2006, the Corporation recognizes compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. In accordance with SFAS 123(R), commencing January 1, 2006, the Corporation estimates the number of options for which the requisite service is expected to be rendered as compared to accounting for forfeitures as they occur under SFAS 123. The Corporation has chosen to recognize compensation expense for new grants using the

-7-

Note 1 - Summary of Significant Accounting Policies - Continued 

straight-line method which spreads compensation expense for shares vesting evenly over the period of vesting. Pro forma disclosures under SFAS 123 have been based upon the accrual method which treats each vesting tranche as a separate award and amortizes expense evenly (prorated) from grant date to vest date for each tranche. The Corporation estimates that share-based compensation expense, net of tax, to be recognized during the year of 2006 will be approximately $407,000. The number and timing of options granted during 2006 and vesting criteria may alter this projected number. See Note 5 - Stock Based Compensation for additional information.
 
In October 2005, the FASB issued Staff Position (FSP) No. 123(R)-2, “Practical Accommodation to the Application of Grant Date as Defined in SFAS No. 123(R).” The FSP stipulates that assuming all other criteria in the grant date definition are met, a mutual understanding of the key terms and conditions of an award to an individual employee is presumed to exist upon the award’s approval in accordance with the relevant corporate governance requirements, provided that the terms and conditions of an award (a) cannot be negotiated by the recipient with the employer and (b) are expected to be communicated to an individual recipient within a relatively short time period from the date of approval. FSP 123(R)-2 applies upon initial adoption of SFAS 123(R). The adoption of this FSP did not have any impact on the Corporation’s financial position or results of operations.

In November 2005, the FASB issued FSP No. 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payments Awards.” The FSP provides an alternative transition method for accounting for the tax effects of share-based payment awards to employees for entities that do not have the necessary information to comply with the transition requirements of SFAS 123(R). An entity may take up to one year from the later of its initial adoption of SFAS 123(R) or the effective date of this FSP (November 10, 2005) to evaluate its available transition alternatives and make its one-time election.

In February 2006, the FASB issued FSP No. 123(R)-4, “Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event” to amend guidance in SFAS 123(R) on classifying options and similar instruments issued as part of employee compensation arrangements. Prior to amendment, SFAS 123(R) required the classification of such instruments as liabilities if the entity could be required under any circumstances to settle the option or similar instrument by transferring cash or other assets. FSP 123(R)-4 amends certain paragraphs of SFAS 123(R) to incorporate a practical accommodation similar to the probability approach provided in footnote 16 of the statement for shares subject to contingent cash settlement features. As a result, SFAS 123(R) requires options issued as compensation to employees to be classified as liabilities if the cash settlement feature can be exercised only upon the occurrence of a contingent event that is outside the employee's control, and such event is deemed probable to occur. Accounting for the modification of the option or similar instrument from equity to liability is similar to accounting for a modification from an equity to liability award. This FSP is applicable upon initial adoption of SFAS 123(R). FSP 123(R)-4 did not have any impact on the Corporation’s financial position or results of operations.

For additional information on other significant accounting policies, see Note 1 of the Consolidated Financial Statements of the Corporation’s 2005 Annual Report on Form 10-K.

Note 2 - Dispositions / Acquisition
 
On July 26, 2006, the Corporation entered into an agreement for the sale of the Bank’s Honesdale branch located in Wayne County, Pennsylvania with deposits of approximately $74.0 million as well as certain loans and other assets of approximately $25.0 million to the First National Community Bank. The transaction has been approved by the regulators and is expected to close in the fourth quarter of 2006. Harleysville National Bank anticipates recording a pre-tax profit on the sale of approximately $10.5 million, or approximately $.23 per share, diluted, net of tax during the fourth quarter of 2006(1). The sale of this single Wayne County location will allow the Corporation to focus on expanding within its core markets and also help to provide the resources required to support strategic initiatives.

On April 14, 2006, the Bank sold its existing credit card portfolio to Elan Financial Services, a national credit card issuer and established an agent issuing relationship with Elan Financial Services. Under the agreement, credit cards for the Bank will be issued under the Harleysville National Bank name. The Bank sold $15.3 million in credit card receivables resulting in a gain in the second quarter of 2006 from the sale of these credit cards, net of federal income taxes, of approximately $939,000 or $.03 per diluted share. The Bank continues to earn certain fees from ongoing portfolio activity. The sale agreement stipulates that any credit card accounts delinquent

__________________________________

(1) The statements above relating to anticipated pre-tax profit during the fourth quarter of 2006 are forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Whether or not the corporate and per share profits resulting from the transaction result as anticipated is subject to a variety of factors, including but not limited to consummation of the sale agreement and deposit attrition and legal, settlement and integration expenses greater than expected.
 
-8-


Note 2 - Dispositions / Acquisition - Continued

over 30 days, overlimit accounts and petitioned bankruptcies will be guaranteed by the Bank for a period of one year. Of the $15.3 million in credit card receivables sold, $529,000 was sold with full recourse which was the total potential recourse exposure at the time of the sale. During the second quarter of 2006, the Bank recorded a recourse liability of $371,000 which was the entire recourse liability recorded. This estimate was based on our historic losses as experienced on similar credit card receivables. The Corporation will be subject to the full recourse obligations for a period of one year. At September 30, 2006, the total potential recourse exposure had been reduced to $266,000 with a current recourse liability of $126,000.

On January 13, 2006, the Corporation completed its acquisition of the Cornerstone Companies, registered investment advisors for high net worth, privately held business owners, wealthy families and institutional clients. Located in the Lehigh Valley, Pennsylvania, the firm specializes in providing sophisticated open architecture asset management platforms, business succession and estate planning services, life insurance sales and compensation and benefits consulting. The Cornerstone Companies had assets under management of approximately $1.5 billion at the acquisition date and serve clients throughout Pennsylvania and other mid-Atlantic states.

The acquisition was consummated pursuant to the Purchase Agreement dated November 15, 2005, by and among the Bank and Cornerstone Financial Consultants, Ltd., a Pennsylvania corporation (CFC), Cornerstone Institutional Investors, Inc., a Pennsylvania corporation (CII), Cornerstone Advisors Asset Management, Inc., a Pennsylvania corporation ((CAAM), and together with CFC and CII collectively, the Cornerstone Companies) and Cornerstone Management Resources, Inc., (CMR). Under the Purchase Agreement, the Bank acquired (i) all of the outstanding capital stock of CFC and CII, (ii) substantially all of the assets of CAAM, and (iii) certain limited assets of CMR. The purchase price consisted of $15.0 million in cash paid at closing and a contingent payment of up to $7.0 million to be paid post-closing. The contingent payment is based upon the Cornerstone Companies meeting certain minimum operating results during a five-year earn-out period, with a maximum payout of $7.0 million over this period.

The Cornerstone Companies acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations.” The Cornerstone’s Companies results of operations are included in the Corporation’s results beginning January 1, 2006 through September 30, 2006. Goodwill and identifiable intangibles of $11.4 million and $3.9 million, respectively, were recorded in connection with the acquisition. During the third quarter of 2006, management finalized the process of evaluating the purchase accounting adjustments. The amortization of the identifiable intangibles totaled $114,000 for the third quarter of 2006 and $336,000 for the first nine months of 2006.

On June 30, 2005, the Bank sold its former subsidiary, Cumberland Advisors, Inc., to David R. Kotok and Associates, Inc. in a stock sale. The sale price was $2.0 million cash and resulted in a non-taxable gain of $287,000 recorded in the second quarter of 2005. Cumberland Advisors had assets of $1.8 million. Cumberland Advisors, based in Vineland, New Jersey, is an SEC registered investment advisor specializing in fixed income money management and equities with approximately $700 million in assets under management at June 30, 2005. It was acquired by the Corporation on April 30, 2004 as part of its Millennium Bank acquisition. Based upon management’s analysis of Cumberland Advisors’ results of operations and assets in comparison to the Corporation’s, management determined the impact of the sale of Cumberland Advisors is immaterial, and therefore the transaction is not presented as discontinued operations.

On April 1, 2005, the Bank completed the sale of its McAdoo branch located in Schuylkill County, Pennsylvania with deposits of $13.9 million as well as certain loans and other assets of $5.8 million to The Legacy Bank. In connection with the sale, the Bank paid net cash of $7.4 million and recorded a pre-tax profit of $690,000 during the second quarter of 2005.
 
Note 3 - Pension Plan
 
The Corporation has a non-contributory defined benefit pension plan covering substantially all employees. The plan’s benefits are based on years of service and the employee’s average compensation during any five consecutive years within the ten-year period preceding retirement.
 
Net periodic defined benefit pension expense for the nine months ended September 30, 2006 and 2005 included the following components:
 
 
  
Nine Months Ended September, 30 
(Dollars in thousands)
    
2006
 
 
2005
  
               
Service cost
  
$
780
  
$
789
  
Interest cost
   
491
    
481
  
Expected return on plan assets
   
(413
)
  
(393
)
Amortization of unrecognized net actuarial loss
   
88
    
70
  
Net periodic benefit expense
 
$
946
  
$
947
  

The Corporation has contributed $750,000 to its pension plan in 2006.
 
 
-9-
 
Note 4 - Stock Dividend/Split

On September 15, 2006, the Corporation paid a five percent stock dividend to shareholders of record as of September 1, 2006. On September 15, 2005, the Corporation paid a five percent stock dividend to shareholders of record as of September 1, 2005. All prior period amounts were restated to reflect these stock dividends.

Note 5 - Stock Based Compensation

The Corporation has four shareholder approved fixed stock option plans that allow the Corporation to grant options up to an aggregate of 3,797,861 shares of common stock to key employees and directors. At September 30, 2006, 2,517,985 stock options had been granted under the stock option plans. The options have a term of ten years when issued and typically vest over a five-year period. The exercise price of each option is the market price of the Corporation’s stock on the date of grant. Additionally, at September 30, 2006, the Corporation has an additional 328,310 granted stock options as a result of the Millennium Bank acquisition. The options have a term of ten years and are exercisable at prices ranging from $9.25 to $13.81.

At January 1, 2006, the Corporation began recognizing compensation expense for stock options with the adoption of SFAS 123(R) under the modified prospective application method of transition. Prior to January 1, 2006, the Corporation followed SFAS 123 and APB 25 with pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS 123 has been applied. Effective January 1, 2006, the Corporation recognizes compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. See Note 1 - Summary of Significant Accounting Policies for additional information.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions based on historical data used for grants for the nine months ended September 30, 2006 and 2005, respectively: weighted-average dividend yield of 3.52% and 2.86%; weighted-average expected volatility of 32.19% and 29.66%; weighted average risk-free interest rate of 4.64% (4.42% to 5.08%) and 4.04% (3.79% to 4.06%): and a weighted-average expected life of 7.28 years and 6.96 years. Expected volatility is based on the historical volatility of the Corporation’s stock over the expected life of the grant. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury strip rate in effect at the time of the grant. The life of the option is based on historical factors which include the contractual term, vesting period, exercise behavior and employee terminations. In accordance with SFAS 123(R), stock based compensation expense for the nine months ended September 30, 2006 is based on awards that are ultimately expected to vest and therefore has been reduced for estimated forfeitures. The Corporation estimates forfeitures using historical data based upon the groups identified by management. Prior to January 1, 2006, under SFAS 123, forfeitures were accounted for as they occurred. As a result of adopting FAS 123(R) on January 1, 2006, the Corporation’s income before income taxes and net income were lower than if it had continued to account for share based compensation under APB 25 by $97,000 and $93,000, respectively, for the third quarter of 2006 and $345,000 and $315,000, respectively, for the nine-month period ending September 30, 2006.
 
The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS 123(R) to stock-based employee compensation for the three and nine months ended September 30, 2005 (all per share information has been adjusted retroactively for the effect of stock dividends). 

(Dollars in thousands, except per share amounts)
    
Three Months Ended
 
 
Nine Months Ended
  
 
September 30, 2005 
Net income
              
As reported
 
$
10,162
  
$
29,017
  
Stock-based compensation expense included in
reported net income, net of related tax effects
    
-
    
-
  
Stock-based compensation expense determined
under fair value based method for all awards,
net of related tax effects
    
(106
)
  
(503
)
 Pro forma
  
$
10,056
  
$
28,514
  
               
Earnings per share (Basic)
             
As reported
  
$
.35
  
$
1.00
  
 Pro forma
  
$
.35
  
$
.99
  
               
Earnings per share (Diluted)
             
As reported
  
$
.34
  
$
.98
  
 Pro forma
  
$
.34
  
$
.97
  
 
 
-10-
Note 5 - Stock Based Compensation - Continued

A summary of option activity under the Corporation’s stock option plans as of September 30, 2006, and changes during the nine months ended September 30, 2006 is presented in the following table. The number of shares and weighted-average share information have been adjusted to reflect stock dividends.
 
Options
    
Shares
 
 
Weighted-Average Exercise Price
 
 
Weighted-Average Remaining Contractual Term
(in years)
 
 
Aggregate
Intrinsic Value
(in thousands)
 
Outstanding at January 1, 2006
    
1,650,387
  
$
14.27
              
Granted
    
18,900
    
18.60
              
Exercised
    
(399,798
)
  
9.50
             
Forfeited (unvested)
    
(57,359
)
  
22.70
             
Cancelled (vested)
    
(26,260
)
  
17.67
              
                           
Outstanding at September 30, 2006
    
1,185,870
  
$
15.46
    
5.61
  
$
7,333
  
                           
Exercisable at September 30, 2006
    
1,011,614
  
$
14.26
    
5.10
  
$
7,327
  
                           

The weighted-average grant-date fair value of options granted during the nine months ended September 30, 2006 and 2005 was $5.23 and $6.32, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $4.3 million and $2.6 million, respectively. Intrinsic value is measured using the fair market value price of the Corporation’s common stock less the applicable exercise price.

A summary of the status of the Corporation’s nonvested shares as of September 30, 2006 is presented below:

Nonvested Shares
    
Shares
 
 
Weighted-Average
Grant-Date Fair Value
  
               
Nonvested at January 1, 2006
    
229,671
  
$
6.24
  
               
Granted
    
18,900
    
5.23
  
               
Vested
    
(16,955
)
  
5.33
  
               
Forfeited
    
(57,359
)
  
6.27
  
               
Nonvested at September 30, 2006
    
174,257
  
$
6.21
  

As of September 30, 2006, there was a total of $829,000 of unrecognized compensation cost related to nonvested awards under stock option plans. This cost is expected to be recognized over a weighted-average period of 1.8 years. The total fair value of shares vested during the nine months ended September 30, 2006 and 2005 was $90,000 and $293,000, respectively.

Prior to the adoption of FAS 123(R), the Corporation presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the statement of cash flows. Statement 123(R) requires the cash flows resulting from tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $867,000 excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if the company had not adopted FAS 123(R).

Note 6 - Earnings Per Share

Basic earnings per share exclude dilution and are computed by dividing income available to common shareholders by the weighted-average common shares outstanding during the period. Diluted earnings per share take into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. All weighted average, actual shares and per share information in these financial statements have been adjusted retroactively for the effect of stock dividends.
-11-
Note 6 - Earnings Per Share - Continued

The calculations of basic earnings per share and diluted earnings per share are as follows:


 
 
 
 
 
 
Three Months Ended
 Nine Months Ended
 
 September 30,
 September 30,
(Dollars in thousands, except per share data)
2006
2005
2006
2005
         
Basic earnings per share
        
Net income available to common shareholders
$7,907
$10,162
$26,143
$29,017
Weighted average common shares outstanding
29,011,903
28,897,869
28,940,119
28,921,613
Basic earnings per share
$ .27
$ .35
$ .90
$ 1.00
         
Diluted earnings per share
        
Net income available to common shareholders
and assumed conversions
$7,907
$10,162
$26,143
$29,017
Weighted average common shares outstanding
29,011,903
28,897,869
28,940,119
28,921,613
Dilutive potential common shares (1), (2)
372,407
581,359
433,527
619,873
Total diluted weighted average common shares outstanding
29,384,310
29,479,228
29,373,646
29,541,486
Diluted earnings per share
$ .27
$ .34
$ .89
$ .98
         

 
(1)  
Includes incremental shares from assumed conversions of stock options.
(2)  
Antidilutive options have been excluded in the computation of diluted earnings per share because the options’ exercise prices were greater than the average
market price of the common stock. For the three and nine months ended September 30, 2006, there were 417,456 antidilutive options at an average price of $24.50.
For the three and nine months ended September 30, 2005, there were 370,210 antidilutive options at an average price of $25.67 and 372,415 antidilutive options
at an average price of $25.64.

Note 7 - Comprehensive Income

The components of other comprehensive income (loss) are as follows:

Comprehensive Income
                     
(Dollars in thousands)
    
Before tax
 
 
Tax Benefit
 
 
Net of tax
  
Nine months ended September 30, 2006
    
Amount
 
 
(Expense)
 
 
Amount
  
Net unrealized gains on available for sale securities:
                    
Net unrealized holding gains arising during period
  
$
2,035
  
$
(712
)
$
1,323
  
Less reclassification adjustment for net gains realized in net income
    
-
    
-
    
-
  
Net unrealized gains
    
2,035
    
(712
)
  
1,323
  
Change in fair value of derivatives used for cash flow hedges
    
(144
)
  
50
    
(94
)
Amortization of unrealized loss on termination of cash flow hedge
    
137
    
(48
)
  
89
  
Other comprehensive income, net
  
$
2,028
  
$
(710
)
$
1,318
  
                     
(Dollars in thousands)
    
Before tax
 
 
Tax Benefit
 
 
Net of tax
  
Nine months ended September 30, 2005
    
Amount
 
 
(Expense
)
 
Amount
  
Net unrealized losses on available for sale securities:
                    
Net unrealized holding losses arising during period
  
$
(5,533
)
$
1,937
  
$
(3,596
)
Less reclassification adjustment for net gains realized in net income
    
3,047
    
(1,066
)
  
1,981
  
Net unrealized losses
    
(8,580
)
  
3,003
    
(5,577
)
Change in fair value of derivatives used for cash flow hedges
    
552
    
(193
)
  
359
  
Unrealized loss on termination of cash flow hedge
    
(195
)
  
68
    
(127
)
Other comprehensive loss, net
  
$
(8,223
)
$
2,878
  
$
(5,345
)

Note 8 - Segment Information

The Corporation operates two main lines of business along with several other operating segments. SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for public business enterprises to report information about operating segments. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision-maker in deciding how to allocate and assess resources and performance. The Corporation’s chief operating decision-maker is the President and Chief Executive Officer. The Corporation has applied the aggregation criteria set forth in SFAS No. 131 for operating segments establishing two reportable segments: Community Banking and Wealth Management.

-12-
Note 8 - Segment Information - Continued
 
The Community Banking segment provides financial services to consumers, businesses and governmental units primarily in southeastern Pennsylvania. These services include full-service banking, comprised of accepting time and demand deposits, making secured and unsecured commercial loans, mortgages, consumer loans, and other banking services. The treasury function income is included in the Community Banking segment, as the majority of effort of this function is related to this segment. Primary sources of income include net interest income and service fees on deposit accounts. Expenses include costs to manage credit and interest rate risk, personnel, and branch operational and technical support.

The Wealth Management segment includes: trust and investment management services, providing investment management, trust and fiduciary services, estate settlement and executor services, financial planning, and retirement plan and institutional investment services; and the Cornerstone Companies, registered investment advisors for high net worth, privately held business owners, wealthy families and institutional clients. Major revenue components sources include investment management and advisory fees, trust fees, estate and tax planning fees, brokerage fees, and insurance related fees. Expenses primarily consist of personnel and support charges. Additionally, the Wealth Management segment includes an inter-segment credit related to trust deposits which are maintained within the Community Banking segment using a transfer pricing methodology.

The Corporation has also identified several other operating segments. These operating segments within the Corporation’s operations do not have similar characteristics to the Community Banking or Wealth Management segments and do not meet the quantitative thresholds requiring separate disclosure. These non-reportable segments include HNC Reinsurance Company, HNC Financial Company, and the parent holding company and are included in the “Other” category.

Information about reportable segments and reconciliation of the information to the consolidated financial statements follows:

(Dollars in thousands)
    
Community Banking
 
 
Wealth Management
 
 
All Other
 
 
Consolidated Totals
  
Three Months Ended September 30, 2006
                          
                           
Net interest income (expense)
  
$
21,060
  
$
118
  
$
(564
)
$
20,614
  
Provision for loan losses
    
900
    
-
    
-
    
900
  
Noninterest income
    
4,738
    
3,377
    
171
    
8,286
  
Noninterest expense
    
14,108
    
3,141
    
311
    
17,560
  
Income (loss) before income taxes (benefit)
    
10,790
    
354
    
(704
)
  
10,440
  
Income taxes (benefit)
    
2,698
    
132
    
(297
)
  
2,533
  
Net income (loss)
  
$
8,092
  
$
222
  
$
(407
)
$
7,907
  
                           
Three Months Ended September 30, 2005
                          
                           
Net interest income
  
$
21,778
  
$
147
  
$
(181
)
$
21,744
  
Provision for loan losses
    
650
    
-
    
-
    
650
  
Noninterest income
    
5,761
    
1,268
    
701
    
7,730
  
Noninterest expense
    
13,937
    
1,315
    
61
    
15,313
  
Income (loss) before income taxes (benefit)
    
12,952
    
100
    
459
    
13,511
  
Income taxes (benefit)
    
3,228
    
34
    
87
    
3,349
  
Net income (loss)
  
$
9,724
  
$
66
  
$
372
  
$
10,162
  
 
Nine Months Ended September 30, 2006
                          
                           
Net interest income (expense)
  
$
64,495
  
$
383
  
$
(1,517
)
$
63,361
  
Provision for loan losses
    
3,000
    
-
    
-
    
3,000
  
Noninterest income
    
15,208
    
11,471
    
560
    
27,239
  
Noninterest expense
    
41,783
    
9,788
    
889
    
52,460
  
Income (loss) before income taxes (benefit)
    
34,920
    
2,066
    
(1,846
)
  
35,140
  
Income taxes (benefit)
    
8,899
    
864
    
(766
)
  
8,997
  
Net income (loss)
  
$
26,021
  
$
1,202
  
$
(1,080
)
$
26,143
  
                           
Assets
  
$
3,310,306
  
$
18,706
  
$
33,991
  
$
3,363,003
  
                           
Nine Months Ended September 30, 2005
                          
                           
Net interest income
  
$
65,037
  
$
464
  
$
(240
)
$
65,261
  
Provision for loan losses
    
2,050
    
-
    
-
    
2,050
  
Noninterest income
    
15,189
    
5,258
    
1,978
    
22,425
  
Noninterest expense
    
41,769
    
5,747
    
193
    
47,709
  
Income (loss) before income taxes (benefit)
    
36,407
    
(25
)
  
1,545
    
37,927
  
Income taxes (benefit)
    
8,580
    
(9
)
  
339
    
8,910
  
Net income (loss)
  
$
27,827
  
$
(16
)
$
1,206
  
$
29,017
  
                           
Assets
  
$
3,087,114
  
$
-
  
$
33,024
  
$
3,120,138
  

-13-
Note 8 - Segment Information - Continued

The accounting policies of the segments are the same as those described in the summary of significant accounting policies disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2005. Consolidating adjustments reflecting certain eliminations of inter-segment revenues, cash and investment in subsidiaries are included in the “All Other” segment.

Note 9 - Financial Instruments with Off-Balance Sheet Risk

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amounts of those instruments. The Bank uses the same stringent credit policies in extending these commitments as they do for recorded financial instruments and controls exposure to loss through credit approval and monitoring procedures.

The approximate contract amounts are as follows:
   
Total Amount Committed at
Commitments
  
September 30,
2006
December 31,
 2005
(Dollars in thousands)
     
Financial instruments whose contract amounts represent credit risk:
    
Commitments to extend credit
$730,535
$722,034
Standby letters of credit and financial guarantees written
25,821
21,661
Financial instruments whose notional or contract amounts exceed the amount of credit risk:
    
Interest rate swap agreements
57,100
22,100

The total committed amount included no credit card unused lines at September 30, 2006 and $44.4 million at December 31, 2005. In April 2006, the Corporation sold its existing credit card portfolio. See Note 2 - Dispositions / Acquisitions for addition information.

At September 30, 2006, the Corporation had cash flow hedges in the form of interest rate swaps totaling $45.0 million that have the effect of converting the rates on money market deposit accounts to a fixed-rate cost of funds. This strategy will cause the Bank to recognize, in a rising rate environment, a larger interest rate spread than it otherwise would have without the swaps in effect. In addition, the Corporation
had cash flow hedges for $10.0 million that have the effect of converting variable debt to a fixed rate. For these swaps, the Corporation recognized net interest income of $134,000 and $29,000 for the three months ended September 30, 2006 and 2005, respectively and $311,000 and $18,000 of net interest income for the nine months ended September 30, 2006 and 2005, respectively. During the first quarter of 2005, the Corporation terminated a cash flow hedge with a notional value of $25.0 million. The gross loss related to the termination of this swap is $310,000 which is being amortized through October 2006 in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The Corporation amortized into net interest income $46,000 for both the third quarter of 2006 and 2005 related to this swap. For the nine months ended September 30, 2006 and 2005, the Corporation amortized into net interest income $136,000 and $114,000, respectively, related to this swap. Periodically, the Corporation may enter into fair value hedges to limit the exposure to changes in the fair value of loan assets. During December 2005, the Corporation entered into a fair value hedge for $2.1 million with $3,000 of interest income recognized for the three and nine months ended September 30, 2006. The Corporation’s swap agreements have a positive fair market value totaling $502,000 at September 30, 2006 and $623,000 at December 31, 2005.

The Bank also had commitments with customers to extend mortgage loans at a specified rate at September 30, 2006 and December 31, 2005 of $1.9 million and $1.8 million, respectively and commitments to sell mortgage loans at a specified rate at September 30, 2006 and December 31, 2005 of $1.3 million and $1.1 million, respectively. The commitments are accounted for as a derivative and recorded at fair value. The Bank estimates the fair value of these commitments by comparing the secondary market price at the reporting date to the price specified in the contract to extend or sell the loan initiated at the time of the loan commitment. The commitments had a positive fair value at September 30, 2006 of $10,000 and $320 at December 31, 2005, which was recorded as other income.

-14-
 

Note 9 - Financial Instruments with Off-Balance Sheet Risk - Continued
 
During December 2004 and January 2005, the Bank sold lease financing receivables of $10.5 million. Of these leases, $1.2 million were sold with full recourse and the remaining leases were sold subject to recourse with a maximum exposure of ten percent of the outstanding receivable. The total recourse exposure at the time of the sale of the leases was $2.0 million. During the first quarter of 2005, the Bank recorded a recourse liability of $216,000 which was the entire recourse liability recorded. This estimate was based on our historic losses as experienced on similar lease financing receivables. After the first anniversary of the sale agreement, and on a quarterly basis thereafter, upon written request by the Bank, the purchaser will review the portfolio performance and may reduce the total exposure to an amount equal to ten percent of the outstanding net book value. The Corporation will be subject to the full and partial recourse obligations until all the lease financing receivables have been paid or otherwise been terminated and all equipment has been sold or disposed of. The final lease payment is due in 2010 with approximately 90% of the lease financing receivables estimated to be paid down by December 31, 2007. The outstanding balance of these sold leases at September 30, 2006 was $3.8 million with a total recourse exposure of $769,000 and a current recourse liability of $175,000.

Note 10 - Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans¾an amendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS No. 158 requires an employer that is a business entity and sponsors one or more single-employer defined benefit plans to 1) recognize a plan’s overfunded or underfunded status as an asset or liability in its financial statements, 2) measure plan assets and obligations as of fiscal year-end, and 3) recognize as a component of other comprehensive income, net of tax, the gains and losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. The statement is effective for fiscal years ending after December 15, 2006 with the exception of the requirement to measure plan assets and obligations as of the employer’s fiscal year-end which is effective for fiscal years ending after December 15, 2008. The Corporation is in the process of determining the impact this statement will have on its financial statements. If the provisions of SFAS No. 158 had been applied as of December 31, 2005, shareholder’s equity would have been reduced by approximately $1.8 million after tax. The Corporation’s current measurement date for plan assets and obligations is fiscal year-end.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, although earlier application is encouraged. Prospective application of the provisions of SFAS No. 157 is required as of the beginning of the fiscal year in which it is initially applied, except for certain circumstances specified in the Statement that require retrospective application. The Corporation is in the process of assessing the impact of the adoption of this statement on the Corporation’s financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108 to add section N, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” to Topic 1, Financial Statements, of the Staff Accounting Bulletin Series. Section N provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. These methods are referred to as the “roll-over” and “iron curtain” methods. The roll-over method quantifies the amount by which the current year income statement is misstated. Exclusive reliance on an income statement approach can result in the accumulation of errors on the balance sheet that may not have been material to any individual income statement, but which may misstate one or more balance sheet accounts. The iron curtain method quantifies the error as the cumulative amount by which the current year balance sheet is misstated. Exclusive reliance on a balance sheet approach can result in disregarding the effects of errors in the current year income statement that results from the correction of an error existing in previously issued financial statements. We currently use the roll-over method for quantifying identified financial statement misstatements. According to the guidance, a registrant must quantify the impact of correcting all misstatements on its current year financial statements, including both the carryover and reversing effects of prior year misstatements. Early application of the guidance in SAB No. 108 is encouraged in any report for an interim period of the first fiscal year ending after November 15, 2006, filed after the publication of this SAB. The Corporation is in the process of assessing the impact of applying the guidance in this SAB on the Corporation’s financial results.

In June, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.” FIN No. 48 clarifies the accounting and reporting for income taxes where interpretation of the tax law may be uncertain. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 will apply to fiscal years beginning after December 15, 2006, with earlier adoption permitted. The Corporation is in the process of assessing the impact of the adoption of this statement on the Corporation’s financial results.
-15-


Note 10 - Recent Accounting Pronouncements - Continued

In March 2006, the FASB issued SFAS No. 156, “Amending Accounting for Separately Recognized Servicing Assets and Servicing Liabilities,” to simplify accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 amends SFAS No. 140, “ Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” to require an entity to 1) separately recognize financial assets as servicing assets or servicing liabilities, each time it undertakes an obligation to service a financial asset by entering into certain kinds of servicing contracts, 2) initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable and 3) separately present servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. Additionally, SFAS No. 156 permits an entity to choose either the amortization method or the fair value measurement method for measuring each class of separately recognized servicing assets and servicing liabilities. SFAS 156 applies to all separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity's fiscal year that begins after September 15, 2006, although early adoption is permitted. The Corporation is in the process of assessing the impact of the adoption of this statement on the Corporation’s financial results.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments¾an amendment of FASB Statements No. 133 and 140,” to simplify and make more consistent the accounting for certain financial instruments. SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” to permit fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. Prior to fair value measurement, interests in securitized financial assets must be evaluated to identify interests containing embedded derivatives requiring bifurcation. The amendments to SFAS 133 also clarify which interest-only and principal-only strips are not subject to the requirements of SFAS 133, and that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS 155 amends SFAS No. 140, “Accounting for the Impairment or Disposal of Long-Lived Assets,” to allow a qualifying special-purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006, with earlier application allowed. The Corporation is in the process of determining the impact this statement will have on its financial statements.
 
In November 2005, the FASB issued FSP FAS Nos. 115-1 and FAS 124-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” to give guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other than temporary, and on measuring such impairment loss. This FSP nullifies certain requirements of EITF Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and supersedes EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.” This FSP nullifies the requirements of paragraphs 10-18 of Issue 03-1, carries forward the requirements of paragraphs 8 and 9 of Issue 03-1 with respect to cost-method investments, carries forward the disclosure requirements included in paragraphs 21 and 22 of Issue 03-1 and related examples, and references existing other-than-temporary guidance. The guidance in this FSP applies to reporting periods beginning after December 15, 2005. The adoption of this FSP did not have a material impact on the Corporation’s results of operations or financial condition.
 
In November, 2005, the FASB issued FSP FIN 45-3, “Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners.” The guidance in this FSP amends FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to explicitly state that the recognition, measurement and disclosure provisions of FIN No. 45 apply to a minimum revenue guarantee. A minimum revenue guarantee is a guarantee granted to a business or its owners that the revenue of the business will be at least a specified minimum amount for a specified period of time. FSP FIN 45-3 is effective for new minimum revenue guarantees issued or modified on or after the beginning of the first fiscal quarter following November 10, 2005 (the date posted to the FASB website). The disclosure requirements are to be applied to all minimum revenue guarantees in financial statements of interim or annual periods ending after the beginning of the first fiscal quarter following November 10, 2005, although earlier application is permitted. FSP FIN 45-3 did not have a material impact on the Corporation’s financial position or results of operations.

-16-


Item 2.                                                                                               MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION

The following is management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Corporation, the Bank, HNC Financial Company and HNC Reinsurance Company. The Corporation’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Current performance does not guarantee, and may not be indicative, of similar performance in the future. These are unaudited financial statements and, as such, are subject to year-end audit review.

In addition to historical information, this Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We have made forward-looking statements in this report, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When we use words such as “believes,” “expects,” “anticipates,” “may,” “estimates,” or “intends” or similar expressions, we are making forward-looking statements. Forward-looking statements are representative only as of the date they are made, and the Corporation undertakes no obligation to update any forward-looking statement.

Shareholders should note that many factors, some of which are discussed elsewhere in this report and in the documents that we incorporate by reference, could affect the future financial results of the Corporation and its subsidiaries and could cause those results to differ materially from those expressed or implied in our forward-looking statements contained or incorporated by reference in this document. These factors include but are not limited to those described in Item 1A, “Risk Factors” in the Corporation’s 2005 Annual Report on Form 10-K and in this Form 10-Q.

Critical Accounting Estimates

The accounting and reporting policies of the Corporation and its subsidiaries conform to accounting principles generally accepted in the United States and general practices with the financial services industry. The Corporation’s significant accounting policies are described in Note 1 of the consolidated financial statements in this Form 10-Q and in the Corporation’s 2005 Annual Report on Form 10-K and are essential in understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition. In applying accounting policies and preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Therefore, actual results could differ significantly from those estimates. Judgments and assumptions required by management, which have, or could have a material impact on the Corporation’s financial condition or results of operations are considered critical accounting estimates. The following is a summary of the policies the Corporation recognizes as involving critical accounting estimates: Allowance for Loan Loss, Goodwill and Other Intangible Asset Impairment, Stock-Based Compensation, Unrealized Gains and Losses on Debt Securities Available for Sale, and Deferred Taxes.

Allowance for Loan Losses: The Corporation maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated probable credit losses. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including current and anticipated economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Corporation’s results of operations in the future.

Goodwill and Other Intangible Asset Impairment: Goodwill and other intangible assets are reviewed for potential impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Goodwill is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Corporation employs general industry practices in evaluating the fair value of its goodwill and other intangible assets. The Corporation calculates the fair value using a combination of the following valuations: deposit premiums based on market deals, current stock pricing tracking as a multiple of book value, discounted cash flow of earnings with a terminal value and market multiple of earnings. Management performed its annual review of goodwill at June 30, 2006 and determined there was no impairment of goodwill. No assurance can be given that future impairment tests will not result in a charge to earnings.
 

-17-

Share-based Compensation: The Corporation adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (FAS 123(R)) on January 1, 2006 using the modified prospective application method of transition. FAS 123(R) was issued by the FASB in December 2004, requiring all forms of share-based payments to employees, including employee stock options, be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the option is generally measured at fair value at the grant date with compensation expense recognized over the service period, which is usually the vesting period. Prior to January 1, 2006, the Corporation followed SFAS 123 and APB 25 with pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS 123 has been applied. Effective January 1, 2006, the Corporation recognizes compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. The Corporation estimates the fair value of options under the Black-Scholes model which takes into consideration the exercise price and expected life of the options, the current price of the underlying stock and its expected volatility, the expected dividends on the stock and the current risk-free interest rate for the expected life of the option. The Corporation’s estimate of the fair value of a stock option is based on expectations derived from historical experience and may not necessarily equate to its market value when fully vested. In accordance with SFAS 123(R), the Corporation estimates the number of options for which the requisite service is expected to be rendered as compared to accounting for forfeitures as they occur under SFAS 123. The Corporation has chosen to recognize compensation expense for new grants using the straight-line method which spreads compensation expense for shares vesting evenly over the period of vesting. Pro forma disclosures under SFAS 123 have been based upon the accrual method which treats each vesting tranche as a separate award and amortizes expense evenly (prorated) from grant date to vest date for each tranche. The Corporation estimates that share-based compensation expense, net of tax, to be recognized during the year of 2006 will be approximately $407,000. The number and timing of options granted during 2006 and vesting criteria may alter this projected number. During the third quarter of 2006, the Corporation recognized share-based compensation expense of $97,000 ($93,000 net of tax) and for the nine-month period ending September 30, 2006, recognized $345,000 ($315,000, net of tax). As of September 30, 2006, there was a total of $829,000 of unrecognized compensation cost related to nonvested awards under stock option plans ($798,000 net of tax). This cost is expected to be recognized over a weighted-average period of 1.8 years.

Unrealized Gains and Losses on Debt Securities Available for Sale: The Corporation receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Debt securities available for sale are mostly comprised of mortgage-backed securities.

Deferred Taxes: The Corporation recognizes deferred tax assets and liabilities for the future effects of temporary differences, net operating loss carryforwards, and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realizations are likely. If management determines that the Corporation may not be able to realize some or all of the net deferred tax asset in the future, a charge to income tax expense may be required to reduce the value of the net deferred tax asset to the expected realizable value.

The Corporation has not substantively changed its application of the foregoing policies, and there have been no material changes in assumptions or estimation techniques used as compared to prior periods.

Financial Overview

For the third quarter of 2006, the Corporation’s diluted and basic earnings per share were $.27 compared to $.34 and $.35, respectively, for the third quarter of 2005. Net income was $7.9 million for the third quarter of 2006 compared to $10.2 million during the third quarter of 2005.

For the nine months ended September 30, 2006, diluted and basic earnings per share were $.89 and $.90, respectively, as compared to $.98 and $1.00, respectively in the comparable period of 2005. Net income for the nine-month period ended September 30, 2006, was $26.1 million compared to $29.0 million during the nine months of 2005. The net interest margin compression for the Corporation, as well as the banking industry in general, continues to be challenging due to the interest rate environment. Wealth management income during the third quarter of 2006 rose to $3.4 million, an increase of $2.1 million from the comparable period in 2005. In addition, total deposits grew 11.1% from December 31, 2005. The earnings for 2006 reflected increases in interest expense on deposits and borrowings partially offset by increases in loan interest income and wealth management income.

The year-to-date financial results for 2006 include the favorable impact on operations from the acquisition of the Cornerstone Companies effective January 1, 2006 and the $1.4 million gain on the sale of the Bank’s credit card portfolio during the second quarter. The per share results also reflect the issuance of 1,382,000 shares of the Corporation’s common stock for a 5% stock dividend payable September 15, 2006. All share and per share information has been restated to reflect this stock dividend.

The Corporation’s consolidated total assets were $3.4 billion at September 30, 2006, an increase of 7.8% or $242.9 million over $3.1 billion in total assets reported at September 30, 2005. This increase was primarily attributable to loan growth of $92.4 million and an increase in cash and investments of $124.7 million. The growth in loans took place mainly in the Bank’s real estate portfolio. Total assets at September 30, 2006 increased $245.6 million compared to December 31, 2005 with $48.8 million growth in loans and a $168.7
 
-18-
million net increase in cash and investments. Total deposits increased $262.8 million to $2.63 billion at September 30, 2006 from $2.37 billion at December 31, 2005 mostly attributable to growth in time deposits and interest-bearing checking accounts.

For the three months ended September 30, 2006, the annualized return on average shareholders’ equity and the annualized return on average assets were 11.10% and .96%, respectively. For the same period in 2005, the annualized return on average shareholders’ equity was 14.64% and the annualized return on average assets was 1.32%. The decrease in these ratios during 2006 was primarily the result of lower net income.

Nonperforming assets (including nonaccrual loans, net assets in foreclosure and loans 90 days or more past due) were .39% of total assets at September 30, 2006, compared to .27% at December 31, 2005, and .26% at September 30, 2005. The increase in nonperforming assets at September 30, 2006, in relation to December 31, 2005, was mainly due to commercial mortgage loans for two borrowers totaling $2.2 million, which were placed on nonaccrual of interest during the first quarter of 2006, commercial mortgage loans for another borrower totaling $803,000, which were placed on nonaccrual of interest during the second quarter of 2006 and commercial mortgage loans for three borrowers totaling $916,000 which became delinquent over 90 days during the third quarter of 2006. The increase in relation to September 30, 2005, was attributed to the previously aforementioned loans as well as an additional $657,000 attributed to commercial loan borrowers placed on nonaccrual of interest during the fourth quarter of 2005. 
 
Results of Operations

Net income is affected by five major elements: (1) net interest income, or the difference between interest income earned on loans and investments and interest expense paid on deposits and borrowed funds; (2) the provision for loan losses, or the amount added to the allowance for loan losses to provide reserves for inherent losses on loans; (3) noninterest income, which is made up primarily of certain fees, wealth management income and gains and losses from sales of securities; (4) noninterest expense, which consists primarily of salaries, employee benefits and other operating expenses; and (5) income taxes. Each of these major elements will be reviewed in more detail in the following discussion.

Net Interest Income

Net interest income on a tax equivalent basis in the third quarter of 2006 decreased $1.2 million or 5.2% from the same period in 2005 and net interest income on a tax equivalent basis for the nine months ended September 30, 2006 decreased $2.3 million or 3.2% from the nine-month period ending September 30, 2005. These decreases during 2006 were mainly attributable to higher deposit and borrowing costs offset in part by higher loan and investment rates. Due to the market conditions, deposit and short-term borrowing rates have increased more quickly than loan rates have increased.

The rate volume variance analysis in the table below, which is computed on a tax-equivalent basis (tax rate of 35%), analyzes changes in net interest income for the three and nine months ended September 30, 2006 compared to September 30, 2005 by their volume and rate components. The change attributable to both volume and rate has been allocated proportionately.

Table 1—Analysis of Changes in Net Interest Income—Fully Taxable-Equivalent Basis

 
  
Three Months Ended 
Nine Months Ended
 
  
September 30, 2006 compared to 
September 30, 2006 compared to
(Dollars in thousands)
  
September 30, 2005
September 30, 2005
                                       
   
Total 
 
Due to change in:
 
Total
 
Due to change in:
 
 
Change 
 
 
Volume
 
 
Rate
 
 
Change
 
 
Volume
 
 
Rate
  
                                       
Increase in interest income:
                                      
Investment securities *
  
$
1,562
  
$
147
  
$
1,415
  
$
3,948
  
$
759
  
$
3,189
  
Federal funds sold and deposits in banks
    
809
    
473
    
336
   
1,513
    
554
    
959
  
Loans *
    
4,937
    
1,849
    
3,088
   
15,731
    
6,035
    
9,696
  
Total
    
7,308
    
2,469
    
4,839
    
21,192
    
7,348
    
13,844
  
                                       
Increase (decrease) in interest expense:
                                      
Savings and money market deposits
    
4,714
    
370
    
4,344
    
11,826
    
386
    
11,440
  
Time deposits
   
3,569
    
1,957
    
1,612
    
9,211
    
5,274
    
3,937
  
Borrowed funds
    
238
    
(676
)
  
914
    
2,412
    
(443
)
  
2,855
  
Total
    
8,521
    
1,651
    
6,870
    
23,449
    
5,217
    
18,232
  
                                       
Net increase (decrease) in net interest income
  
$
(1,213
)
$
818
  
$
(2,031
)
$
(2,257
)
$
2,131
  
$
(4,388
)
*Tax equivalent basis using a tax rate of 35%
                                      


-19-

The following table presents the major asset and liability categories on an average basis for the periods presented, along with interest income and expense, and key rates and yields.

Table 2—Average Balance Sheets and Interest Rates¾Fully Taxable-Equivalent Basis

(Dollars in thousands)
  
Three Months Ended September 30,
Three Months Ended September 30,
   
2006
2005
                                       
 
    
Average 
 
 
 
 
 
Average
 
 
Average
 
 
 
 
 
Average
  
Assets
    
Balance
 
 
Interest
 
 
Rate
 
 
Balance
 
 
Interest
 
 
Rate
  
Earning assets:
                                      
Investment securities:
                                      
Taxable investments
  
$
661,976
  
$
7,538
    
4.52
%
$
642,405
  
$
5,678
    
3.51
%
Nontaxable investments (1)
    
255,127
   
3,892
    
6.05
    
261,519
    
4,190
    
6.36
  
Total investment securities
    
917,103
   
11,430
    
4.94
    
903,924
    
9,868
    
4.33
  
Federal funds sold and deposits in banks
    
92,878
    
1,227
    
5.24
    
50,489
    
418
    
3.28
  
Loans (1) (2)
    
2,027,028
    
34,823
    
6.82
    
1,912,551
    
29,886
    
6.20
  
Total earning assets
    
3,037,009
   
47,480
    
6.20
    
2,866,964
    
40,172
    
5.56
  
Noninterest-earning assets
    
216,607
   
         
187,931
              
Total assets
  
$
3,253,616
              
$
3,054,895
              
                                       
Liabilities and Shareholders' Equity
                                      
Interest-bearing liabilities:
                                      
Interest-bearing deposits:
                                      
Savings and money market
  
$
1,305,618
    
10,630
    
3.23
  
$
1,232,136
    
5,916
    
1.90
  
Time
    
878,493
    
9,732
    
4.40
    
685,168
    
6,163
    
3.57
  
Total interest-bearing deposits
    
2,184,111
    
20,362
    
3.70
    
1,917,304
    
12,079
    
2.50
  
Borrowed funds
    
409,583
    
4,985
    
4.83
    
471,579
    
4,747
    
3.99
  
Total interest bearing liabilities
    
2,593,694
    
25,347
    
3.88
    
2,388,883
    
16,826
    
2.79
  
Noninterest-bearing liabilities:
                                      
Demand deposits
   
334,847
                
343,658
              
Other liabilities
    
42,397
                
46,904
              
Total noninterest-bearing liabilities
    
377,244
                
390,562
              
Total liabilities
    
2,970,938
                
2,779,445
              
Shareholders' equity
    
282,678
                
275,450
              
Total liabilities and shareholders' equity
  
$
3,253,616
              
$
3,054,895
              
Net interest spread
                
2.32
                
2.77
  
Effect of noninterest-bearing sources
                
0.57
                
.46
  
Net interest income/margin on earning assets
        
$
22,133
    
2.89
%
      
$
23,346
    
3.23
%
                                       
Less tax equivalent adjustment
          
1,519
               
1,602
       
Net interest income
        
$
20,614
              
$
21,744
        


-20-


(Dollars in thousands)
  
Nine Months Ended September 30,
Nine Months Ended September 30,
 
 
2006
2005
                                       
 
    
Average 
 
 
 
 
 
Average
 
 
Average
 
 
 
 
 
Average
  
Assets
    
Balance
 
 
Interest
 
 
Rate
 
 
Balance
 
 
Interest
 
 
Rate
  
Earning assets:
                                      
Investment securities:
                                      
Taxable investments
  
$
675,138
  
$
22,412
    
4.44
%
$
641,102
  
$
17,362
    
3.62
%
Nontaxable investments (1)
    
252,447
    
11,573
    
6.13
    
263,993
    
12,675
    
6.42
  
Total investment securities
    
927,585
    
33,985
    
4.90
    
905,095
    
30,037
    
4.44
  
Federal funds sold and deposits in banks
    
67,181
    
2,507
    
4.99
    
46,773
    
994
    
2.84
  
Loans (1) (2)
    
2,007,650
    
100,333
    
6.68
    
1,879,230
    
84,602
    
6.02
  
Total earning assets
    
3,002,416
   
136,825
    
6.09
    
2,831,098
    
115,633
    
5.46
  
Noninterest-earning assets
    
209,946
   
         
181,633
              
Total assets
  
$
3,212,362
              
$
3,012,731
              
                                       
Liabilities and Shareholders' Equity
                                      
Interest-bearing liabilities:
                                      
Interest-bearing deposits:
                                      
Savings and money market
  
$
1,264,577
    
27,061
    
2.86
  
$
1,234,032
    
15,235
    
1.65
  
Time
    
841,242
    
26,341
    
4.19
    
659,241
    
17,130
    
3.47
  
Total interest-bearing deposits
    
2,105,819
    
53,402
    
3.39
    
1,893,273
    
32,365
    
2.29
  
Borrowed funds
    
445,688
    
15,517
    
4.65
    
460,933
    
13,105
    
3.80
  
Total interest bearing liabilities
    
2,551,507
    
68,919
    
3.61
    
2,354,206
    
45,470
    
2.58
  
Noninterest-bearing liabilities:
                                      
Demand deposits
   
338,709
                
335,015
              
Other liabilities
    
42,918
                
50,590
              
Total noninterest-bearing liabilities
    
381,627
                
385,650
              
Total liabilities
    
2,933,134
                
2,739,811
              
Shareholders' equity
    
279,228
                
272,920
              
Total liabilities and shareholders' equity
  
$
3,212,362
              
$
3,012,731
              
Net interest spread
                
2.48
                
2.88
  
Effect of noninterest-bearing sources
                
0.54
                
.43
  
Net interest income/margin on earning assets
        
$
67,906
    
3.02
%
      
$
70,163
    
3.31
%
                                       
Less tax equivalent adjustment
          
4,545
               
4,902
       
Net interest income
        
$
63,361
              
$
65,261
        

(1)  
The interest earned on nontaxable investment securities and loans is shown on a tax equivalent basis (tax rate of 35%).
(2)  
Nonaccrual loans have been included in the appropriate average loan balance category, but interest on nonaccrual loans has not been included for purposes of determining interest income.

Interest income on a tax equivalent basis in the third quarter of 2006 increased $7.3 million, or 18.2% over the same period in 2005. This increase was primarily due to higher average rates earned on loans and investment securities of 62 basis points and 61 basis points, respectively, and an increase in average loans of $114.5 million, or 6.0%. Interest expense increased $8.5 million during the third quarter of 2006 versus the comparable period in 2005 mainly attributed to higher deposit and short-term borrowing rates as well as an increase in average time deposits of $193.3 million. The average rate paid on deposits during the third quarter of 2006 of 3.70% was 120 basis points higher compared to the same period in 2005 due to higher rates on most deposit products. The average rate paid on borrowings for the third quarter of 2006 of 4.83% was 84 basis points higher than the comparable period in 2005 mainly due to an increase in short-term borrowing rates.

Net Interest Margin

The net interest margin for the third quarter of 2006 was 2.89%, compared to 3.04% for the second quarter of 2006 and 3.23% for the third quarter of 2005. Due to market conditions, deposit and short-term borrowing rates have increased more quickly than loan rates resulting in a lower net interest margin.

-21-
Interest Rate Sensitivity Analysis

In the normal course of conducting business activities, the Corporation is exposed to market risk, principally interest rate risk through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and value of financial instruments.

The Corporation actively manages its interest rate sensitivity positions. The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements and to achieve consistent growth in net interest income. The Asset/Liability Committee, using policies and procedures approved by the Corporation’s Board of Directors, is responsible for managing the rate sensitivity position. The Corporation manages interest rate sensitivity by changing the mix and repricing characteristics of its assets and liabilities through the management of its investment securities portfolio, its offering of loan and deposit terms and through borrowings from the Federal Home Loan Bank of Pittsburgh (the FHLB). The nature of the Corporation’s current operations is such that it is not subject to foreign currency exchange or commodity price risk.

The Corporation only utilizes derivative instruments for asset/liability management. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations and payments are based. The notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Interest rate swaps are contracts in which a series of interest-rate flows (fixed and floating) are exchanged over a prescribed period. The notional amounts on which the interest payments are based are not exchanged.

At September 30, 2006, the Corporation had cash flow hedges in the form of interest rate swaps totaling $45.0 million that have the effect of converting the rates on money market deposit accounts to a fixed-rate cost of funds. This strategy will cause the Bank to recognize, in a rising rate environment, a larger interest rate spread than it otherwise would have without the swaps in effect. In addition, the Corporation
had cash flow hedges for $10.0 million that have the effect of converting variable debt to a fixed rate. For these swaps, the Corporation recognized net interest income of $134,000 and $29,000 for the three months ended September 30, 2006 and 2005, respectively and $311,000 and $18,000 of net interest income for the nine months ended September 30, 2006 and 2005, respectively. During the first quarter of 2005, the Corporation terminated a cash flow hedge with a notional value of $25.0 million. The gross loss related to the termination of this swap is $310,000 which is being amortized through October 2006 in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The Corporation amortized into net interest income $46,000 for both the third quarter of 2006 and 2005 related to this swap. For the nine months ended September 30, 2006 and 2005, the Corporation amortized into net interest income $136,000 and $114,000, respectively, related to this swap. Periodically, the Corporation may enter into fair value hedges to limit the exposure to changes in the fair value of loan assets. During December 2005, the Corporation entered into a fair value hedge for $2.1 million with $3,000 of interest income recognized for the three and nine months ended September 30, 2006. The Corporation’s swap agreements have a positive fair market value totaling $502,000 at September 30, 2006 and $623,000 at December 31, 2005.

The Corporation uses three principal reports to measure interest rate risk: (1) asset/liability simulation reports; (2) gap analysis reports; and (3) net interest margin reports. Management also simulates possible economic conditions and interest rate scenarios in order to quantify the impact on net interest income. The effect that changing interest rates have on the Corporation’s net interest income is simulated by increasing and decreasing interest rates. This simulation is known as rate shocking. The results of the September 30, 2006 net interest income rate shock simulations show that the Corporation is within guidelines set by the Corporation’s Asset/Liability Policy when rates increase or decrease 100 or 200 basis points.

The report below forecasts changes in the Corporation’s market value of equity under alternative interest rate environments as of September 30, 2006. The market value of equity is defined as the net present value of the Corporation’s existing assets and liabilities. The Corporation is within guidelines set by the Corporation’s Asset/Liability Policy for the percentage change in the market value of equity.
 
Table 3—Market Value of Equity

   
Change in  
    
 
 
 
 
 
 
Asset/Liability
 
 
 
 
Market Value 
 
 
Market Value
 
 
Percentage
 
 
Approved
 
(Dollars in thousands)
    
of Equity
 
 
of Equity
 
 
Change
 
 
Percent Change
 
                           
+300 Basis Points
  
$
337,566
  
$
(106,586
)
  
-24.00
%
  
+/- 35
%
+200 Basis Points
    
376,394
    
(67,758
)
  
-15.26
%
  
+/- 25
 
+100 Basis Points
    
413,414
    
(30,738
)
  
-6.92
%
  
+/- 15
 
Flat Rate
    
444,152
    
-
   
0.00
%
      
-100 Basis Points
    
452,237
    
8,085
    
1.82
%
  
+/- 15
 
-200 Basis Points
    
442,927
    
(1,225
)
  
-0.28
%
  
+/- 25
 
-300 Basis Points
    
428,872
    
(15,280
)
  
-3.44
%
  
+/- 35
 
 
-22-

In the event the Corporation should experience a mismatch in its desired gap ranges or an excessive decline in their market value of equity resulting from changes in interest rates, it has a number of options that it could use to remedy the mismatch. The Corporation could restructure its investment portfolio through the sale or purchase of securities with more favorable repricing attributes. It could also emphasize growth in loan products with appropriate maturities or repricing attributes, or attract deposits or obtain borrowings with desired maturities.

Provision for Loan Losses

The Bank uses the reserve method of accounting for loan losses. The balance in the allowance for loan and lease losses is determined based on management’s review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including management’s assumptions as to future delinquencies, recoveries and losses. Increases to the allowance for loan and lease losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses. Recoveries of previously charged-off amounts are credited to the allowance for loan losses.

While management considers the allowance for loan losses to be adequate based on information currently available, future additions to the allowance may be necessary due to changes in economic conditions or management’s assumptions as to future delinquencies, recoveries and losses and management’s intent with regard to the disposition of loans. In addition, the Office of the Comptroller of the Currency (the OCC), as an integral part of their examination process, periodically reviews the Bank’s allowance for loan losses. The OCC may require the Bank to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examination.

The Bank’s allowance for loan and lease losses is the accumulation of various components that are calculated based on various independent methodologies. The components of the allowance for credit losses consist of both historical losses and estimates. Management bases its recognition and estimation of each allowance component on certain observable data that it believes is the most reflective of the underlying loan losses being estimated. The observable data and accompanying analysis is directionally consistent, based upon trends, with the resulting component amount for the allowance for loan losses. The Bank’s allowance for loan losses components includes the following: historical loss estimation by loan product type and by risk rating within each product type, payment (past due) status, industry concentrations, internal and external variables such as economic conditions, credit policy and underwriting changes and competence of the loan review process. The Bank’s historical loss component is the most significant component of the allowance for loan losses, and all other allowance components are based on the inherent loss attributes that management believes exist within the total portfolio that are not captured in the historical loss component.

The historical loss components of the allowance represent the results of analyses of historical charge-offs and recoveries within pools of homogeneous loans, within each risk rating and broken down further by segment, within the portfolio. Criticized assets are further assessed based on trends, expressed as percentages, relative to delinquency, risk rating and nonaccrual, by credit product.

The historical loss components of the allowance for commercial loans are based principally on current risk ratings, historical loss rates adjusted, by adjusting the risk window, to reflect current events and conditions, as well as analyses of other factors that may have affected the collectibility of loans. The Bank analyzes all commercial loans that have been identified as having potential risk. The review is accomplished via Watchlist Memoranda, and designed to determine whether such loans are individually impaired, with impairment measured by reference to the collateral coverage and/or debt service coverage. The historical loss component of the allowance for consumer loans is based principally on loan payment status, retail classification and historical loss rates adjusted, by adjusting the risk window, to reflect current events and conditions.

The industry concentration component is recognized as a possible factor in the estimation of loan losses. Two industries represent possible concentrations: commercial real estate and consumer loans relying on residential home equity. No specific loss-related observable data is recognized by management currently, therefore no specific factor is calculated in the reserve solely for the impact of these concentrations, although management continues to carefully consider relevant data for possible future sources of observable data.

The historic loss model includes a judgmental component (environmental factors) that reflects management’s belief that there are additional inherent credit losses based on loss attributes not adequately captured in the lagging indicators. Furthermore, given that past-performance indicators may not adequately capture current risk levels, allowing for a real-time adjustment enhances the validity of the loss recognition process. There are many credit risk management reports that are synthesized by credit management staff to assess the direction of credit risk and its instant effect on losses. It is important to continue to use experiential data to confirm risk as measurable losses will continue to manifest themselves at higher than normal levels even after the economic cycle has begun an upward swing and lagging indicators begin to show improvement. The judgmental component is allocated to the specific segments of the portfolio based on the historic loss component.
 
-23-
 
For the third quarter of 2006, the provision for loan losses was $900,000, compared to $650,000 for the same period in 2005. For the nine months ended September 30, 2006, the provision for loan losses was $3.0 million compared to $2.1 million for the same period in 2005. The increase in the provision was primarily a result of inherent risk related to loan growth and the increase in nonperforming loans. Net loans charged off were $214,000 for the third quarter of 2006 compared to $335,000 for the same quarter in 2005.
A summary of the activity in the allowance for loan losses is as follows:

Table 4—Allowance for Loans Losses
 
  
Nine Months Ended 
 
  
September 30, 
(Dollars in thousands)
    
2006
    
2005
  
               
Average loans
  
$
2,007,650
  
$
1,879,230
  
               
Allowance, beginning of period
   
19,865
   
18,455
 
Loans charged off:
              
Commercial and industrial
   
469
   
282
 
Consumer
    
1,253
    
1,467
  
Real estate
   
483
   
144
  
Lease financing
   
18
    
31
  
Total loans charged off
   
2,223
    
1,924
  
Recoveries:
              
Commercial and industrial
   
48
    
65
  
Consumer
    
412
   
301
  
Real estate
   
114
    
197
  
Lease financing
   
87
   
61
 
Total recoveries
    
661
   
624
 
Net loans charged off
   
1,562
   
1,300
  
Provision for loan losses
   
3,000
   
2,050
  
Allowance, end of period
 
$
21,303
  
$
19,205
  
Ratio of net charge offs to average
              
loans outstanding (annualized)
   
0.10
%
  
0.09
%
               
 
The following table sets forth an allocation of the allowance for loan losses by loan category. The specific allocations in any particular category may be reallocated in the future to reflect then current conditions. Accordingly, management considers the entire allowance to be available to absorb losses in any category.

Table 5—Allocation of the Allowance for Loan Losses by Loan Type

 
  
September 30, 2006 
December 31, 2005
 
    
 
 
 
Percent of 
 
 
 
 
 
Percent of
  
(Dollars in thousands)
    
Amount
 
 
Reserve
 
 
Amount
 
 
Reserve
  
                           
Real estate
  
$
7,802
    
37
%
$
6,422
    
32
%
Commercial
                         
and industrial
    
8,895
   
42
%
  
8,534
    
43
%
Consumer
    
4,512
   
21
%
  
4,596
    
23
%
Lease financing
    
94
   
-
%
  
313
    
2
%
Total
  
$
21,303
    
100
%
$
19,865
    
100
%
 
-24-
Nonperforming Assets

Nonperforming assets (including nonaccruing loans, net assets in foreclosure and loans past due 90 days or more past due) were .39% of total assets at September 30, 2006, compared to .27% at December 31, 2005, and .26% at September 30, 2005. The increase in nonperforming assets at September 30, 2006, in relation to December 31, 2005, was mainly due to commercial mortgage loans for two borrowers totaling $2.2 million, which were placed on nonaccrual of interest during the first quarter of 2006, commercial mortgage loans for another borrower totaling $803,000, which were placed on nonaccrual of interest during the second quarter of 2006 and commercial mortgage loans for three borrowers totaling $916,000 which became delinquent over 90 days during the third quarter of 2006. The increase in relation to September 30, 2005, was attributed to the previously aforementioned loans as well as an additional $657,000 attributed to commercial loan borrowers placed on nonaccrual of interest during the fourth quarter of 2005.

Net assets in foreclosure decreased $382,000 at September 30, 2006 from September 30, 2005 mainly due to proceeds received on disposals of foreclosed properties. Efforts to liquidate assets acquired in foreclosure proceed as quickly as potential buyers can be located and legal constraints permit. Foreclosed assets are carried at the lower of cost (lesser of carrying value of asset or fair value at date of acquisition) or estimated fair value. Loans past due 90 days or more and still accruing interest are loans that are generally well secured and are in the process of collection.

The following table presents information concerning nonperforming assets. Nonperforming assets include loans that are 90 days or more past due or in nonaccrual status and loans that are in the process of foreclosure.

Table 6—Nonperforming Assets

(Dollars in thousands)
    
September 30, 2006
 
 
December 31, 2005
 
 
September 30, 2005
  
                     
 Nonaccrual loans
 
$
10,806
  
$
7,493
  
$
6,388
  
 Loans 90 days or more past due
    
2,262
    
846
    
1,125
  
Total nonperforming loans
   
13,068
    
8,339
    
7,513
  
 Net assets in foreclosure
    
87
    
29
    
469
  
Total nonperforming assets
  
$
13,155
  
$
8,368
  
$
7,982
  
                     
  Allowance for loan losses to nonperforming loans
   
163.0
%
  
238.2
%
  
255.6
%
 Nonperforming loans to total net loans
   
0.65
%
  
0.42
%
  
0.39
%
 Allowance for loan and lease losses to total loans
   
1.05
%
  
1.00
%
  
0.99
%
 Nonperforming assets to total assets
    
0.39
%
  
0.27
%
  
0.26
%
 
The following table presents information concerning impaired loans. Impaired loans are loans for which it is probable that all principal and interest will not be collected according to the contractual terms of the loan agreement.

Table 7—Impaired Loans

(Dollars in thousands)
    
September 30, 2006
    
December 31, 2005
    
September 30, 2005
  
                     
Impaired Loans
  
$
3,260
  
$
3,317
  
$
1,330
  
                 
 
Average year-to-date impaired loans
  
$
3,027
  
$
1,542
  
$
1,285
  
                 
 
Impaired loans with specific loss allowances
  
$
3,260
  
$
3,317
  
$
1,330
  
                     
Loss allowances reserved on impaired loans
  
$
483
  
$
675
  
$
151
  
                     
Year-to-date income recognized on impaired loans
  
$
50
  
$
33
  
$
19
  

The Bank’s policy for interest income recognition on impaired loans is to recognize income under the cash basis when the loans are both current and the collateral on the loan is sufficient to cover the outstanding obligation to the Bank. The Bank will not recognize income if these factors do not exist.
 
-25-
Noninterest Income

Noninterest income of $8.3 million for the third quarter of 2006 reflects an increase of $556,000 or 7.2% from the comparable period in 2005. For the nine-month period ended September 30, 2006, noninterest income rose to $27.2 million, up $4.8 million or 21.5% from the same period in 2005.

The acquisition of the Cornerstone Companies was the primary driver of increases in wealth management income of $2.1 million during the third quarter of 2006 and $6.0 million for the nine months ended September 30, 2006, over the comparable periods last year, partially offset by the sale of Cumberland Advisors, which was divested in the second quarter of 2005. Major revenue component sources of wealth management income include investment management and advisory fees, trust fees, estate and tax planning fees, brokerage fees, and insurance related fees.

During the second quarter of 2006, the Bank’s credit card portfolio of $15.3 million was sold for a pre-tax gain of $1.4 million. The Bank sold its exiting credit card portfolio on April 14, 2006 to Elan Financial Services, a national credit card issuer and established an agent issuing relationship with Elan Financial Services. Under the agreement, credit cards for the Bank will be issued under the Harleysville National Bank name. The Bank continues to earn certain fees from ongoing portfolio activity. Noninterest income during 2006 also included increases in net revenue resulting from credit card operations.

There were no gains on sales of investment securities during 2006 as compared to gains of $1.9 million during the third quarter of 2005 and $3.0 million for the nine-month period ended September 30, 2005. The net security gains were primarily the result of the sale of equity securities during the first quarter of 2005, the sale of trust-preferred securities with call provisions in the near term during the second quarter of 2005 and the sales of tax-exempt securities and equities securities during the third quarter of 2005.

Noninterest income for 2005 included gains of $690,000 and $287,000 on the sales of Harleysville National Bank’s McAdoo branch and Cumberland Advisors, Inc., respectively during the second quarter.

Noninterest Expense

Noninterest expense of $17.6 million for the third quarter of 2006 increased $2.2 million or 14.7% from $15.3 million in the third quarter of 2005, and increased $4.8 million or 10.0% for the nine months ended September 30, 2006, over the comparable period in 2005.

Salaries and benefits expense increased $2.3 million during the third quarter of 2006 and $4.0 million during the first nine months of 2006 from the comparable periods in 2005, primarily related to the acquisition of the Cornerstone Companies, partially offset by the sale of Cumberland Advisors in the second quarter of 2005, increased staffing levels resulting from growth, non-recurring compensation and severance charges primarily related to the former Chief Executive Officer’s contract which totaled approximately $740,000 and compensation expense of $97,000 for the quarter and $345,000 for the nine months resulting from recording the Corporation’s stock option expense in conformance with FAS 123(R), “Stock Based Compensation.”

Occupancy expense increased $367,000 for the nine months ended September 30, 2006 over the same period in 2005 mostly due to the Cornerstone Companies acquisition and a new branch opening. Other expense increased $1.6 million for the nine months of 2006 mainly as a result of the Cornerstone Companies acquisition including amortization of identifiable intangibles of $336,000. Marketing expense decreased $596,000 for the nine months of 2006 from the comparable period in 2005 primarily due to a more targeted marketing strategy and use of more cost-effective means of advertising during 2006.

Federal Income Taxes

The effective federal income tax rate for the quarter ended September 30, 2006 was 23.7% and for the nine months ended September 30, 2006 was 24.6% versus the statutory rate of 35%. The Corporation’s effective rate during 2006 is lower than the statutory tax rate primarily as a result of tax-exempt income earned from state and municipal securities and loans and bank-owned life insurance. The effective income tax rate for the third quarter of 2005 was 24.6% and for the first nine months of 2005 was 23.0%. The Corporation’s effective rate during 2005 was lower than the statutory tax rate primarily as a result of tax-exempt income earned from state and municipal securities and loans and bank-owned life insurance as well as the non-taxable gain on the sale of Cumberland Advisors, Inc. during the second quarter of 2005.

-26-
 
Balance Sheet Analysis

Total assets at September 30, 2006 of $3.4 billion increased $245.6 million compared to December 31, 2005 with $48.8 million growth in loans and a $168.7 million net increase in cash and investments. The growth in loans took place mainly in real estate loans. Federal funds sold to correspondent bank increased $146.5 million resulting from an increase in public fund checking accounts due to the annual tax collection season for municipalities. The balance of investment securities available for sale at September 30, 2006 of $863.4 million increased $21.7 million compared to December 31, 2005 primarily as a result of net additional purchases of tax-exempt securities. The increases in goodwill and intangible assets were primarily related to the acquisition of the Cornerstone Companies during the first quarter of 2006 which included $11.4 million of goodwill and $3.9 million of identifiable intangibles (with a weighted average amortization period of 9.3 years) allocated to the Wealth Management segment.

Total deposits increased $262.8 million to $2.63 billion at September 30, 2006 from $2.37 billion at December 31, 2005 mostly attributable to growth in time deposits and interest-bearing checking accounts. Core deposits (total deposits less time deposits) increased $116.2 million or 7.2% to $1.73 billion for the same periods. Total borrowings decreased $33.3 million to $405.8 million at September 30, 2006 from $439.2 million at December 31, 2005. The decrease was the result of reductions of $58.0 million in long-term Federal Home Loan Bank borrowings offset in part by increases of $25.0 million in short-term securities sold under agreements to repurchase and fed funds purchased.

Capital

Capital formation is important to the Corporation's well being and future growth. Capital for the period ending September 30, 2006 was $286.6 million, an increase of $13.4 million over the end of 2005. The increase was primarily the result of the retention of the Corporation's earnings and issuances of stock for stock options including tax benefits partially offset by dividends paid to shareholders. Management believes that the Corporation's current capital and liquidity positions are adequate to support its operations. Management is not aware of any recommendations by any regulatory authority, which, if it were to be implemented, would have a material effect on the Corporation's capital.

Table 8—Regulatory Capital
 
 
(Dollars in thousands)
              
 
For Capital
Adequacy Purposes
To Be Well Capitalized
Under Prompt Corrective
Action Program
 
As of September 30, 2006
    
Actual
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
  
                                       
Total Capital (to risk weighted assets):
                                      
Corporation
  
$
317,653
    
12.26
%
$
207,326
    
8.00
%
$
259,158
    
-
  
Harleysville National Bank
    
272,675
    
10.58
%
  
206,122
    
8.00
%
  
257,653
    
10
%
Tier 1 Capital (to risk weighted assets):
                                      
Corporation
    
296,250
    
11.43
%
  
103,663
    
4.00
%
  
155,495
    
-
  
Harleysville National Bank
    
251,272
    
9.75
%
  
103,061
    
4.00
%
  
154,592
    
6
%
Tier 1 Capital (to average assets):
                                      
Corporation
    
296,250
    
9.24
%
  
128,251
    
4.00
%
  
160,313
    
-
  
Harleysville National Bank
    
251,272
    
7.92
%
  
129,905
    
4.00
%
  
158,631
    
5
%

 
 
(Dollars in thousands)
          
 
 
 
For Capital
Adequacy Purposes
To Be Well Capitalized
Under Prompt Corrective
Action Program
 
As of December 31, 2005
    
Actual
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
  
                                       
Total Capital (to risk weighted assets):
                                      
Corporation
  
$
318,911
    
12.98
%
$
196,563
    
8.00
%
$
245,703
    
-
  
Harleysville National Bank
    
259,883
    
10.64
%
  
195,390
    
8.00
%
  
244,238
    
10
%
Tier 1 Capital (to risk weighted assets):
                                      
Corporation
    
298,946
    
12.17
%
  
98,281
    
4.00
%
  
147,422
    
-
  
Harleysville National Bank
   
239,918
    
9.82
%
  
97,695
    
4.00
%
  
146,543
    
6
%
Tier 1 Capital (to average assets):
                                      
Corporation
    
298,946
    
9.69
%
  
123,408
    
4.00
%
  
154,260
    
-
  
Harleysville National Bank
    
239,918
    
7.86
%
  
122,154
    
4.00
%
  
152,693
    
5
%


-27-
 
Pursuant to the federal regulators’ risk-based capital adequacy guidelines, the components of capital are called Tier 1 and Tier 2 capital. For the Corporation, Tier 1 capital is the shareholders’ equity and Tier 2 capital is the allowance for loan losses. The minimum for the Tier 1 ratio is 4.0% and the total capital ratio (Tier 1 plus Tier 2 capital divided by risk-adjusted assets) minimum is 8.0%. At September 30, 2006, the Corporation’s Tier 1 risk-adjusted capital ratio was 11.43%, and the total risk-adjusted capital ratio was 12.26%, both well above the regulatory requirements. The risk-based capital ratios of the Bank also exceeded regulatory requirements at September 30, 2006.

The leverage ratio consists of Tier 1 capital divided by quarterly average total assets, excluding intangible assets. Banking organizations are expected to have ratios from 4% to 5%, depending upon their particular condition and growth plans. Higher leverage ratios could be required by the particular circumstances or risk profile of a given banking organization. The Corporation’s leverage ratios were 9.24% at September 30, 2006 and 9.69% at December 31, 2005. The lower leverage ratio of the Corporation at September 30, 2006 was mainly due to the decrease in Tier 1 capital from the additional disallowed goodwill and identifiable intangibles related to the acquisition of the Cornerstone Companies.

The year-to-date September 30, 2006 cash dividend per share of $.55 was 10.0% higher than the cash dividend for the same period in 2005 of $.50. The proportion of net income paid out in dividends for the first nine months of 2006 was 61.2%, compared to 49.73% for the same period in 2005. Activity in both the Corporation’s dividend reinvestment and stock purchase plan did not have a material impact on capital during the first nine months of 2006.

Liquidity

Liquidity is a measure of the ability of the Bank to meet its current cash needs and obligations on a timely basis. For a bank, liquidity provides the means to meet the day-to-day demands of deposit customers and the needs of borrowing customers. Generally, the Bank arranges its mix of cash, money market investments, investment securities and loans in order to match the volatility, seasonality, interest sensitivity and growth trends of its deposit funds. The Corporation’s decisions with regard to liquidity are based on projections of potential sources and uses of funds for the next 120 days under the Corporation’s asset/liability model. The resulting projections as of September 30, 2006 show the potential sources of funds exceeding the potential uses of funds. The accuracy of this prediction can be affected by limitations inherent in the model and by the occurrence of future events not anticipated when the projections were made. The Corporation has external sources of funds which can be drawn upon when funds are required. The primary source of external liquidity is an available line of credit with the FHLB. As of September 30, 2006, the Bank had borrowings outstanding with the FHLB of $239.8 million, all of which were long-term and pledged investment securities available for sale of $655.9 million. At September 30, 2006, the Bank had unused lines of credit at the FHLB of $606.5 million and unused federal funds lines of credit of $145.0 million.

Recent Federal Deposit Insurance Corporation (FDIC) Rules
 
 Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC merged the Bank Insurance Fund (BIF) and Savings Insurance Fund (SAIF) to form the Deposit Insurance Fund (DIF) effective March 31, 2006.

On April 1, 2006, the FDIC issued an interim rule, made final in September 2006, to implement the deposit insurance coverage changes of the Federal Deposit Insurance Reform Act of 2005. The rule: (1) increases the deposit insurance limit for certain retirement plan deposits to $250,000 effective April 1, 2006 (the basic insurance limit for other depositors such as individuals, joint accountholders, businesses, government entities and trusts remains at $100,000), (2) provides per-participant insurance coverage to employee benefit plan accounts, even if the depository institution at which the deposits are placed is not authorized to accept employee benefit plan deposits and (3) allows the FDIC to consider inflation adjustments to increase the insurance limits for all deposit accounts every five years, beginning in 2010.

On November 2, 2006, the FDIC set the designated reserve ratio for the deposit insurance fund at 1.25% of estimated insured deposits, and adopted final regulations to implement the risk-based deposit insurance assessment system mandated by the Deposit Insurance Reform Act of 2005, which is intended to more closely tie each bank's deposit insurance assessments to the risk it poses to the deposit insurance fund. Under the new risk-based assessment system, the FDIC will evaluate each institution's risk based on three primary factors -- supervisory ratings for all insured institutions, financial ratios for most institutions, and long-term debt issuer ratings for large institutions that have them. An institution’s assessment rate will depend upon the level of risk it poses to the deposit insurance system as measured by these factors. The new rates for most institutions will vary between 5 and 7 cents for every $100 of domestic insurable deposits.

The new assessment rates will take effect at the beginning of 2007. However, the Deposit Insurance Reform Act of 2005 provides credits to institutions that paid high premiums in the past to bolster the FDIC's insurance reserves, as a result of which the FDIC has announced that a majority of banks will have assessment credits to initially offset all of their premiums in 2007. Due to the number of uncertain factors that could affect the assessment rate the FDIC will decide to apply to the Bank and the assessment credit that will actually be available to the Bank in 2007, management does not believe it is possible at this time to reliably estimate the net assessment cost, if any, that may be imposed on the Bank.

-28-

Other Information

Pending Legislation

Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation’s results of operations.

Effects of Inflation

Inflation has some impact on the Corporation and the Bank’s operating costs. Unlike many industrial companies, however, substantially all of the Bank’s assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Corporation’s and the Bank’s performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services.

Effect of Government Monetary Policies

The earnings of the Corporation are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. An important function of the Federal Reserve is to regulate the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities and changes in reserve requirements against member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect rates charged on loans or paid for deposits.

The Bank is a member of the Federal Reserve and, therefore, the policies and regulations of the Federal Reserve have a significant effect on its deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Bank’s operations in the future. The effect of such policies and regulations upon the future business and earnings of the Corporation and the Bank cannot be predicted.

Environmental Regulations

There are several federal and state statutes, which regulate the obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, a bank may be held liable under certain circumstances for the actions of its borrowers, or third parties, when such actions result in environmental problems on properties that collateralize loans held by the bank. Further, the liability has the potential to far exceed the original amount of a loan issued by the bank. Currently, neither the Corporation nor the Bank are a party to any pending legal proceeding pursuant to any environmental statute, nor are the Corporation and the Bank aware of any circumstances that may give rise to liability under any such statute.

Branching

The Corporation is currently planning to open new locations in Warminster (Bucks County), Plymouth Meeting (Montgomery County) and Warrington (Bucks County) during 2007. In addition, the Corporation is planning to relocate its Blue Bell and Collegeville offices in Montgomery County during 2007. These plans are subject to change as management continues to evaluate its market and its business needs. The Corporation continues to evaluate potential new branch sites that are contiguous to our current service area and will expand the Bank’s market area and market share of loans and deposits.


-29-
 
Item 3 - Qualitative and Quantitative Disclosures About Market Risk
 
    In the normal course of conducting business activities, the Corporation is exposed to market risk, principally interest risk, through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments. The Asset/Liability Committee, using policies and procedures approved by the Bank’s Board of Directors, is responsible for managing the rate sensitivity position.
 
    No material changes in market risk strategy occurred during the third quarter of 2006. A detailed discussion of market risk is provided on pages 22 and 23 of this Form 10-Q.

Item 4 - Controls and Procedures

(i) Management’s Report on Disclosure Controls

Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner.

(ii) Changes in Internal Controls

In connection with the ongoing review of the Corporation’s internal controls over financial reporting as defined in rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, the Corporation regularly assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. There have been no changes in the Corporation’s internal control over financial reporting during the third quarter of 2006 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
 

-30-
 
PART II. OTHER INFORMATION

Item 1. Legal Proceedings
 
Management, based upon discussions with the Corporation's legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its subsidiaries - the Bank, HNC Financial Company and HNC Reinsurance Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation and its subsidiaries by government authorities.


Item 1A. Risk Factors

There have been no material changes in risk factors from those disclosed under Item 1A, “Risk Factors.” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2005.


Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
The following table presents the repurchase activity of the Corporation’s stock repurchase programs during the third quarter of 2006 (all share information has been restated retroactively for the effect of stock dividends and splits). The repurchased shares will be used for general corporate purposes.


 
    
Total Number of Common Shares Purchased 
    
Weighted Average Price Paid Per Share
 
 
Total Number of Shares Purchased as Part of Publicly Announced Plans(1)
 
 
Maximum Number of Shares that may yet be Purchased under the Plans(1)
 
                           
July 1-31, 2006
    
-
 
$
-
    
-
   
1,046,661
  
August 1-31, 2006
    
-
   
-
   
-
   
1,046,661
  
September 1-30, 2006
   
127,400
   
20.39
   
127,400
   
919,261
  
Total
    
127,400
  
$
20.39
    
127,400
        

(1)  
On December 14, 2000, the Board of Directors authorized a program to purchase up to 1,377,023 shares (restated for stock dividends and splits), or 5%, of its outstanding common stock. This repurchase plan was completed during the second quarter of 2005. On May 12, 2005, the Board of Directors authorized a plan to purchase up to 1,416,712 shares (restated for five percent stock dividend paid on September 15, 2006 and September 15, 2005) or 4.9%, of its outstanding common stock.
 
Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Submission of Matters to a Vote of Security Holders

Not Applicable

Item 5. Other Information

(a)  
None to report.

(b)  
There were no changes in the manner shareholders may recommend nominees to the Registrant’s Board of Directors.

Item 6. Exhibits


The exhibits listed on the Exhibit Index at the end of this Report are filed with or incorporated as part of this Report (as indicated in connection with each Exhibit).


 
-31-




SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



                                             HARLEYSVILLE NATIONAL CORPORATION


 

Date: November 8, 2006                           /s/ Demetra M. Takes                                         
Demetra M. Takes, President, Chief Executive Officer and Director
                                               (Principal executive officer)



Date: November 8, 2006                              /s/ George S. Rapp                                    
                      George S. Rapp, Executive Vice President and Chief Financial Officer
                 (Principal financial and accounting officer)



-32-

EXHIBIT INDEX

Exhibit No Description of Exhibits

(2.1)
 
Purchase Agreement, dated as of November 15, 2005, by and among Harleysville National Bank and Trust Company, Cornerstone Financial Consultants, Ltd., Cornerstone Advisors Asset Management, Inc., Cornerstone Institutional Investors, Inc., Cornerstone Management Resources, Inc., John R. Yaissle, Malcolm L. Cowen, II, and Thomas J. Scalici. The schedules and exhibits to the Purchase Agreement are listed at the end of the Purchase Agreement but have been omitted from the exhibit to Form 10-K. The Registrant agrees to supplementally furnish a copy of any omitted schedule or exhibit to the Securities and Exchange Commission upon request. (Incorporated by reference to Exhibit 2.1 of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Commission on March 15, 2006.)
 
(2.2)
 
Branch Purchase Agreement and Deposit Assumption Agreement, dated as of July 26, 2006, by and among First National Community Bank and Harleysville National Bank and Trust Company, filed herewith. The attachments, schedules and exhibits to the Branch Purchase and Deposit Assumption Agreement are listed at the end of the Branch Purchase and Deposit Assumption Agreement but have been omitted from the exhibit to Form 10-Q. The Registrant agrees to supplementally furnish a copy of any omitted attachment, schedule or exhibit to the Securities and Exchange Commission upon request.
 
(3.1)
 
Harleysville National Corporation Amended and Restated Articles of Incorporation. (Incorporated by reference to Exhibit 3.1 to the Corporation’s Registration Statement No. 333-111709 on Form S-4, as filed on January 5, 2004.)
 
(3.2)
 
Harleysville National Corporation Amended and Restated By-laws. (Incorporated by reference to Exhibit 3.1 to the Corporation’s Current Report on Form 8-K, filed with the Commission on February 14, 2005.)
 
(10.1)
 
Harleysville National Corporation 1993 Stock Incentive Plan.** (Incorporated by reference to Exhibit 4.3 of Registrant’s Registration Statement No. 33-69784 on Form S-8, filed with the Commission on October 1, 1993.)
 
(10.2)
 
Harleysville National Corporation Stock Bonus Plan.*** (Incorporated by reference to Exhibit 99A of Registrant’s Registration Statement No. 333-17813 on Form S-8, filed with the Commission on December 13, 1996.)
 
(10.3)
 
Supplemental Executive Retirement Plan.* (Incorporated by reference to Exhibit 10.3 of Registrant’s Annual Report in Form 10-K for the year ended December 31, 1997, filed with the Commission on March 27, 1998.)
 
(10.4)
 
Walter E. Daller, Jr., Chairman and former President and Chief Executive Officer’s Employment Agreement dated October 26, 1998.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 25, 1999.)
 
(10.5)
 
Consulting Agreement and General Release dated November 12, 2004 between Walter E. Daller, Jr., Harleysville National Corporation and Harleysville National Bank and Trust Company.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on November 16, 2004.)
 
(10.6)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Walter E. Daller, Jr.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
(10.7)
 
Employment Agreement dated October 26, 1998 by and among Harleysville National Corporation, Harleysville National Bank and Trust Company and Demetra M. Takes, President and Chief Executive Officer of Harleysville National Bank and Trust Company.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 25, 1999.)
 
(10.8)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Demetra M. Takes, President and Chief Executive Officer of Harleysville National Bank and Trust Company.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
(10.9)
 
Harleysville National Corporation 1998 Stock Incentive Plan.** (Incorporated by reference to Registrant’s Registration Statement No. 333-79971 on Form S-8, filed with the Commission on June 4, 1999.)
 
(10.10)
 
Harleysville National Corporation 1998 Independent Directors Stock Option Plan, as amended and restated effective February 8, 2001.** (Incorporated by reference to Appendix “A” of Registrant’s Definitive Proxy Statement, filed with the Commission on March 9, 2001.)
 
(10.11)
 
Supplemental Executive Retirement Benefit Agreement dated February 23, 2004 between Michael B. High, Executive Vice President and former Chief Financial Officer, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q, filed with the Commission on May 10, 2004.)
 
(10.12)
 
Employment Agreement effective April 1, 2005 between Michael B. High, Executive Vice President and Chief Operating Officer of the Corporation, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on November 16, 2004.)
 
(10.13)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Michael B. High, Executive Vice President and Chief Operating Officer of the Corporation.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
 
-33-
 
(10.14)
 
Employment Agreement dated March 9, 2004 between Mikkalya Murray, Executive Vice President and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q, filed with the Commission on May 10, 2004.)
 
(10.15)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Mikkalya Murray, Executive Vice President.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
(10.16)
 
Harleysville National Corporation 2004 Omnibus Stock Incentive Plan.** (Incorporated by reference to Exhibit B of Registrant’s Definitive Proxy Statement, filed with the Commission on March 5, 2004).
 
(10.17)
 
Employment Agreement dated August 23, 2004 between James F. McGowan, Jr., Executive Vice President & Chief Credit Officer and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on August 25, 2004.)
 
(10.18)
 
Supplemental Executive Retirement Benefit Agreement dated August 23, 2004 between James F. McGowan, Jr., Executive Vice President & Chief Credit Officer, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on August 25, 2004.)
 
(10.19)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and James F. McGowan, Jr., Executive Vice President & Chief Credit Officer.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
(10.20)
 
Employment Agreement dated September 27, 2004 between John Eisele, Executive Vice President & President of Millennium Wealth Management and Private Banking, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on September 29, 2004.)
 
(10.21)
 
Supplemental Executive Retirement Benefit Agreement dated September 27, 2004 between John Eisele, Executive Vice President & President of Millennium Wealth Management and Private Banking, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on September 29, 2004.)
 
(10.22)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and John Eisele, Executive Vice President & President of Millennium Wealth Management and Private Banking.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
(10.23)
 
Employment Agreement effective January 1, 2005 between Gregg J. Wagner, President and Chief Executive Officer of the Corporation, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on November 16, 2004.)
 
(10.24)
 
Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Gregg J. Wagner, the current President and Chief Executive Officer of the Corporation.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
 
(10.25)
 
Employment Agreement dated May 18, 2005, between George S. Rapp, Senior Vice President and Chief Financial Officer, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on May 20, 2005.)
 
(10.26)
 
Stock Purchase Agreement dated June 30, 2005, between David R. Kotok & Associates, Inc., Harleysville National Corporation and Harleysville National Bank and Trust Company. (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on July 1, 2005.)
 
(10.27)
 
Amended and Restated Declaration of Trust for HNC Statutory Trust III by and among Wilmington Trust Company, as Institutional Trustee and Delaware Trustee, Harleysville National Corporation, as Sponsor, and the Administrators named therein, dated as of September 28, 2005. (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q/A, filed with the Commission on November, 9, 2005.)
 
(10.28)
 
Indenture between Harleysville National Corporation, as Issuer, and Wilmington Trust Company, as Trustee, for Fixed/Floating Rate Junior Subordinated Debt Securities, dated as of September 28, 2005. (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q/A, filed with the Commission on November, 9, 2005.)
 
(10.29)
 
Guarantee Agreement between Harleysville National Corporation and Wilmington Trust Company, dated as of September 28, 2005. (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q/A, filed with the Commission on November, 9, 2005.)
 
(10.30)
 
Employment Agreement effective July 12, 2006 between Lewis C. Cyr, Chief Lending Officer of the Corporation, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on July 12, 2006.)
 
(11)
 
Computation of Earnings per Common Share, incorporated by reference to Note 6 of the Consolidated Financial Statements of this Report on Form 10-Q.
 
(31.1)
 
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
 
(31.2)
 
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
 
(32.1)
 
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith.
 
 
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(32.2)
 
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith.
 

* Management contract or compensatory plan arrangement.
** Shareholder approved compensatory plan pursuant to which the Registrant’s Common Stock may be issued to employees of the Corporation.

*** Non-shareholder approved compensatory plan pursuant to which the Registrant’s Common Stock may be issued to employees of the Corporation.
 
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 EX-2.1 BRANCH AGMT 2 branchpurchaseagreement.htm BRANCH PURCHASE AND DEPOSIT ASSUMPTION AGREEMENT Branch Purchase and Deposit Assumption Agreement
Exhibit 2.1







BRANCH PURCHASE AND DEPOSIT ASSUMPTION AGREEMENT
 

 

 
Between
 
FIRST NATIONAL COMMUNITY BANK
 
as Buyer
 

 
and
 

 
HARLEYSVILLE NATIONAL BANK AND TRUST COMPANY
 
as Seller
 

 

 

 

 

 
July 26, 2006
 


TABLE OF CONTENTS
 
                                                                                                                             Page
 
ARTICLE I
 
SALE OF ASSETS AND ASSUMPTION OF LIABILITIES
 
1.1    Effective Date...................................................................................................................................................................................................................................  1
 
1.2     Sale of Assets and Assumption of Liabilities............................................................................................................................................................................  2
 
1.3     Purchase of Loans..........................................................................................................................................................................................................................  5
 
1.4    Cash Payment, Adjustment of Income and Expenses, and Settlement Procedure................................................................................................................  6
 
1.5    Obligations of Seller on the Effective Date.................................................................................................................................................................................   8
 
1.6    Obligations of Buyer on the Effective Date.................................................................................................................................................................................  9
 
1.7    Indemnification................................................................................................................................................................................................................................ 10
 
ARTICLE II
 
REPRESENTATIONS AND WARRANTIES OF SELLER
 
2.1    Corporate Organization and Standing.......................................................................................................................................................................................... 13
 
2.2    Corporate Authority; Due Authorization; Execution and Delivery; Binding Obligation..................................................................................................... 13
 
2.3    No Violation...................................................................................................................................................................................................................................... 13 
 
2.4    Title to Assets.................................................................................................................................................................................................................................. 14
 
2.5     The Branch....................................................................................................................................................................................................................................... 15
 
2.6    Environmental Matters.................................................................................................................................................................................................................... 16
 
2.7    Other Representations and Warranties........................................................................................................................................................................................  17
 
2.8    No Broker........................................................................................................................................................................................................................................... 18
 
2.9    No Other Warranties........................................................................................................................................................................................................................ 18
 
ARTICLE III
 
REPRESENTATIONS AND WARRANTIES OF BUYER
 
3.1    Corporate Organization and Standing................................................................................................................................................................................................ 18 
 
 
TABLE OF CONTENTS (Continued)
 
3.2    Corporate Authority; Due Authorization; Execution and Delivery; Binding Obligation...................................................................................................... 18
 
3.3    No Violation....................................................................................................................................................................................................................................... 19
 
3.4    No Broker........................................................................................................................................................................................................................................... 19
 
ARTICLE IV
 
OBLIGATIONS OF THE PARTIES PRIOR TO AND AFTER EFFECTIVE DATE
 
4.1    Cooperation and Best Efforts.......................................................................................................................................................................................................... 19
 
4.2    Conduct of Business........................................................................................................................................................................................................................ 20
 
4.3    Access to Records and Properties................................................................................................................................................................................................. 20
 
4.4    Seller Regulatory Applications....................................................................................................................................................................................................... 21
 
4.5    Buyer Regulatory Applications...................................................................................................................................................................................................... 21
 
4.6    Employee Matters............................................................................................................................................................................................................................. 21
 
4.7    Public Announcements and Customer Notices............................................................................................................................................................................ 23
 
4.8    Prohibition Against Certain Disclosures........................................................................................................................................................................................ 24
 
4.9    Prohibition Against Customer and Employee Solicitations......................................................................................................................................................... 24
 
4.10    IRA and Keogh Accounts............................................................................................................................................................................................................... 25
 
4.11    Buyer Account Forms and ATM/Debit Cards.............................................................................................................................................................................. 25
 
4.12    Cooperation and Further Assurances; Correction of Errors....................................................................................................................................................... 26
 
4.13    Certain Transitional Matters............................................................................................................................................................................................................ 26
 
4.14    Buyer Obligation to Maintain Records.......................................................................................................................................................................................... 27
 
4.15    Seller Obligation to Maintain Records........................................................................................................................................................................................... 28
 
4.16    Seller Restrictive Covenants............................................................................................................................................................................................................ 28
 
 
iii
 
TABLE OF CONTENTS (Continued)
 
4.17    Information Returns.........................................................................................................................................................................................................................  29
 
4.18    Casualty.............................................................................................................................................................................................................................................. 29
 
ARTICLE V
 
CONDITIONS PRECEDENT
 
5.1    Conditions Precedent to Buyer’s Obligations................................................................................................................................................................................ 30
 
5.2    Conditions Precedent to Seller’s Obligations................................................................................................................................................................................. 31
 
ARTICLE VI
 
TERMINATION, AMENDMENT AND WAIVER
 
6.1    Termination.......................................................................................................................................................................................................................................... 32
 
6.2    Procedure Upon Termination............................................................................................................................................................................................................ 34
 
6.3    Effect of Termination.......................................................................................................................................................................................................................... 34
 
6.4    Amendment.......................................................................................................................................................................................................................................... 35
 
6.5    Waiver................................................................................................................................................................................................................................................... 35
 
ARTICLE VII
 
MISCELLANEOUS PROVISIONS
 
7.1    Parties in Interest and Assignment................................................................................................................................................................................................... 35
 
7.2    Expenses................................................................................................................................................................................................................................................ 35
 
7.3    Notices................................................................................................................................................................................................................................................... 35
 
7.4    Headings................................................................................................................................................................................................................................................ 36
 
7.5    Defined Terms....................................................................................................................................................................................................................................... 37
 
7.6    Governing Law and Related Matters................................................................................................................................................................................................. 37
 
7.7    Specific Performance............................................................................................................................................................................................................................ 38
 
7.8    Entire Agreement.................................................................................................................................................................................................................................. 38
 

iv
TABLE OF CONTENTS (Continued)
 
ATTACHMENTS

1 - Purchase Prices and Deposit Premium
2 - Allocation of Purchase Price
3 - Calculation of Cash Payment
4 - Index of Defined Terms

EXHIBITS

A - Form of Special Warranty Deed
B - Loan Purchase Agreement
C - Bill of Sale
D - Assignment and Assumption Agreement
E - Residual Processing Agreement

SCHEDULES

A - Furniture, Fixtures and Equipment
B - Contracts
C - Deposit Liabilities
D - Loans
E - Description of Real Estate
F - Severance Benefit



 
v


BRANCH PURCHASE AND DEPOSIT ASSUMPTION AGREEMENT
 
MADE as of and effective this 26th day of July, 2006 by and between FIRST NATIONAL COMMUNITY BANK, a national bank organized under the laws of the United States and having its principal office at 102 East Drinker Street, Dunmore, Pennsylvania 18512 (“Buyer”), and HARLEYSVILLE NATIONAL BANK AND TRUST COMPANY, a national bank organized under the laws of the United States of America and having its principal office at 438 Main Street, Harleysville, Pennsylvania 19438 (“Seller”).
 
Background:
 
Seller wishes to sell and assign to Buyer certain fixed and other assets and certain deposit and other liabilities of the branch office located at 1001 Main Street, Honesdale, Pennsylvania 18431 (hereinafter referred to as the “Branch”).
 
Buyer wishes to purchase those assets and to assume those deposits and other liabilities relating to the Branch, on the terms and subject to the conditions hereinafter set forth, at the prices and with the deposit premium set forth on Attachment 1 hereto.
 
NOW, THEREFORE, in consideration of the mutual agreements contained herein, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties, intending to be legally bound hereby, agree as follows:
 
ARTICLE I  
SALE OF ASSETS AND ASSUMPTION OF LIABILITIES
 
1.1   Effective Date. The closing (the “Closing”) shall be held on a date (hereinafter referred to as the “Effective Date”) to be mutually selected by Buyer and Seller, which date shall be the close of business on a Friday after: (i) all required regulatory approvals have been received and all waiting periods required by law have expired, and (ii) all steps necessary to effect an orderly conversion of account data have been taken. The parties anticipate that the Closing will be held on December 1 or 8, 2006.
 
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1.2   Sale of Assets and Assumption of Liabilities.
 
(a)   Sale of Assets. Seller agrees that, subject to the terms and conditions of this Agreement, it will sell, assign, transfer, convey and deliver to Buyer and Buyer agrees that it will purchase and accept, on the Effective Date, the following assets relating to the Branch:
 
(i)   Real Estate. All of Seller’s right, title and interest in and to the real estate upon which the Branch is located, together with all of the improvements thereon, which real estate is described in Schedule E attached hereto (the “Real Estate”);
 
(ii)   Furniture, Fixtures and Equipment. All of Seller’s right, title and interest in and to the furniture, fixtures and equipment located at the Branch on the date hereof (which shall include the items identified on Schedule A attached hereto), less items disposed of in the ordinary course, plus items acquired in the ordinary course, as shall be set forth in Exhibit A to the Bill of Sale to be delivered by Seller to Buyer on the Effective Date (collectively, the “Furniture, Fixtures and Equipment”);
 
(iii)   Safe Deposit Box Business. All of Seller’s right, title and interest in and to the safe deposit box business (if any) conducted at the Branch (the “Safe Deposit Box Business”);
 
(iv)   Contracts. Subject to the receipt of any necessary third party consents, all of Seller’s right, title and interest in and to the contracts (if any) identified on Schedule B attached hereto (collectively, the “Contracts”);
 
(v)   Deposit Related Loans. All of Seller’s right, title and interest in and to the Deposit Related Loans (as defined in Section 1.3(a) below);
 
(vi)   Other Loans. All of Seller’s right, title and interest in and to the Other Loans (as defined in Section 1.3(c) below); and
 
(vii)   Vault Cash. All of Seller’s right, title and interest in and to the cash on hand at the Branch as of the Effective Date (the “Vault Cash”).
 
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The foregoing assets are sometimes hereinafter referred to collectively as the “Purchased Assets.”
 
(b)   Assumption of Liabilities. Seller agrees to assign to Buyer on the Effective Date and Buyer agrees to assume and thereafter to fully and timely perform and discharge in accordance with their terms the following liabilities relating to the Branch:
 
(i)   Deposits. All deposit liabilities (which shall include, but shall not be limited to, “deposits” as such term is defined in Section 3(1)(1) of the Federal Deposit Insurance Act, as amended) of Seller (including balances in money market and other accounts linked to accounts containing deposit liabilities under “sweep” or similar arrangements, together with Seller’s rights and obligations under any related customer agreement, and Individual Retirement Accounts (“IRA’s”) for which Seller is custodian, except any IRA’s for which Seller receives contrary instructions or accounts which by their terms cannot be assumed), together with accrued interest, attributed on the records of Seller to the Branch, as set forth in Schedule C attached hereto, with only such changes therein as shall have occurred in the ordinary course of business of Seller between the date of such Schedule and the Effective Date, as shall be set forth on an updated Schedule C which Seller agrees to deliver to Buyer on the Effective Date, but excluding: (1) deposits subject to legal process, (2) deposits which have been reported as abandoned property under the abandoned property law of any jurisdiction, (3) deposits owned by Seller, (4) deposits constituting official checks, traveler checks, money orders or certified checks of Seller, (5) accounts designated as closed on the books and records of Seller, (6) deposits (if any) pledged as collateral for loans not being purchased by Buyer, (7) all negative deposits and overdrafts on the Effective Date, and (8) brokered deposits (The foregoing deposit liabilities are sometimes hereinafter referred to collectively as the “Deposit Liabilities” and the Deposit Liabilities to be assumed by Buyer hereunder are sometimes hereinafter referred to collectively as the “Assumed Deposits”);
 
(ii)   Safe Deposit Box Business. All of the obligations and liabilities of Seller relating to the Safe Deposit Box Business, to the extent that such liabilities and obligations arise or accrue after the close of business on the Effective Date;
 
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(iii)   Contracts. Subject to the receipt of any necessary third party consents, all of the obligations and liabilities of Seller under the Contracts, to the extent that such liabilities and obligations arise or accrue after the close of business on the Effective Date;
 
(iv)   Deposit Related Loans. All of the obligations of Seller under the Deposit Related Loans (as defined in Section 1.3(a) below), to the extent that such liabilities and obligations arise or accrue after the close of business on the Effective Date; and
 
(v)   Other Loans. All of the obligations of Seller under the Other Loans (as defined in Section 1.3(c) below), to the extent that such liabilities and obligations arise or accrue after the close of business on the Effective Date.
 
The foregoing liabilities are sometimes hereafter referred to collectively as the “Assumed Liabilities.”
 
(c)   Scope. Buyer and Seller acknowledge and agree that Buyer will purchase only the Purchased Assets and that Buyer will assume only the Assumed Liabilities as expressly provided in this Agreement.
 
(d)   Purchase Prices and Deposit Premium. The purchase prices of the Real Estate and the Furniture, Fixtures and Equipment to be paid by Buyer on the Effective Date and the deposit premium to be paid by Buyer on the Effective Date in respect of the Assumed Deposits (the “Deposit Premium”) are set forth on Attachment 1 hereto.
 
(e)   Allocation of Purchase Price. The purchase price for the Purchased Assets (the “Purchase Price”) shall be an amount equal to the sum of: (i) the purchase price of the Real Estate (the “Real Estate Purchase Price”), (ii) the aggregate purchase price of the Furniture, Fixtures and Equipment as set forth on Attachment 1 hereto (the “FF&E Purchase Price”), (iii) the Deposit Related Loan Purchase Price determined in accordance with Section 1.3(b) below; (iv) the aggregate purchase price of the Other Loans determined in accordance with the provisions of Section 2.2 of the Loan Purchase Agreement (the “Other Loan Purchase Price”), (v) the aggregate amount of Vault Cash transferred to Buyer on the Effective Date, and (vi) the
 
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Deposit Premium. Seller and Buyer agree that, upon final determination of the Purchase Price, the Purchase Price shall be allocated and reported for tax purposes in accordance with Attachment 2 hereto.
 
(f)   Licenses, Permits and other Governmental Authorizations. Buyer shall promptly obtain, at its expense, all licenses, permits and other governmental authorizations of any kind that may be required in order to effect the transfer to it of the Purchased Assets and Assumed Liabilities.
 
1.3   Purchase of Loans.
 
(a)   Deposit Related Loans. Buyer shall purchase on the Effective Date all of the loans (if any) identified as Deposit Related Loans on Schedule D (which loans consist of: (i) negative deposits and overdrafts in deposit accounts (provided that no such overdraft or negative deposit shall have been outstanding for more than 30 days as of the Effective Date), and (ii) loans fully secured as to principal and interest by deposits to be assumed by Buyer hereunder), plus loans of the same type made at the Branches in the ordinary course of business, less loans repaid, from the date of such Schedule to the Effective Date (as shall be set forth in an updated Schedule F-1 which Seller agrees to deliver to Buyer on the Effective Date). The foregoing loans are sometimes hereinafter referred to collectively as the “Deposit Related Loans.”
 
(b)   Deposit Related Loan Purchase Price. The purchase price for the Deposit Related Loans shall be equal to the unpaid principal balance thereof outstanding on the Effective Date, plus accrued unpaid interest, plus late charges and fees owed, less prepaid interest, and less any unearned discounts (the “Deposit Related Loan Purchase Price”).
 
(c)   Other Loans. Subject to the right to reject set forth in Section 1.3(d) below, Buyer shall purchase on the Effective Date all of the loans (if any) identified as Other Loans on Schedule D, plus loans of the same type made at the Branch in the ordinary course of business, less loans repaid, from the date of such Schedule to the Effective Date (as shall be set forth in an updated Schedule D which Seller agrees to deliver to Buyer on the Effective Date) in accordance with the terms of the Loan Purchase Agreement attached hereto as Exhibit B (the
 
-5-
 “Loan Purchase Agreement”). The foregoing loans are sometimes hereinafter referred to collectively as the “Loans” or “Other Loans.”
 
(d)   Right to Reject Other Loans. Notwithstanding Section 1.3(c) above, Buyer shall have the right at any time on or before September 30, 2006 to decline to purchase any Other Loan which Buyer determines, in its reasonable discretion and by reference to its existing lending policies, to be deficient in terms of credit quality or loan documentation. Buyer acknowledges and agrees that interest rate considerations shall not constitute a basis for declining to purchase an Other Loan under this Section 1.3(d). Buyer may exercise the foregoing right at any time and from time to time on or before September 30, 2006 by delivering written notice to Seller, which notice shall identify the Other Loan or Other Loans which Buyer declines to purchase and shall specify in each case the reason or reasons why it has elected to reject such Other Loan. Seller shall have the right at any time prior to the Closing to cure any Other Loan which Buyer has rejected by reason of documentary deficiencies; if such deficiencies are cured to Buyer’s reasonable satisfaction, Buyer shall purchase the Other Loan involved at the Closing and if such deficiencies are not cured to Buyer’s reasonable satisfaction, the Other Loan involved shall continue to be treated as having been rejected and Buyer shall not be required to purchase such Other Loan at the Closing.
 
In the case of an Other Loan which is originated and closed after September 30, 2006 and before the Closing, Buyer shall have the rejection right (which may be exercised at any time prior to the Closing) and Seller shall have the right to cure, each as provided for in the immediately preceding paragraph.
 
1.4   Cash Payment, Adjustment of Income and Expenses, and Settlement Procedure.
 
(a)   Cash Payment. Seller shall on the Effective Date pay to Buyer by wire transfer of immediately available funds an amount (the “Cash Payment”) calculated in accordance with Attachment 3 attached hereto.
 
(b)   Pro Rata Adjustment of Income and Expenses; Transfer and Other Taxes. Except as otherwise provided herein or in the Loan Purchase Agreement, all income and operating expenses, accrued or prepaid, including, without limitation, safe deposit box fees,
 
-6-
wages, salaries, rents (including any security deposits, which will be treated as prepaid rent), utility payments, taxes, the Federal Deposit Insurance Corporation (the “FDIC”) premium (if any) and the Financing Corporation (“FICO”) assessments attributable to the Assumed Deposits and similar items of income and expense relating to the Branch or the operations of the Branch shall be pro rated on a daily basis between the parties as of the Effective Date. Buyer and Seller shall each pay one half of all transfer taxes payable in connection with the transfer of the Real Estate.
 
(c)   Settlement Procedure. Notwithstanding the fact that the transactions provided for in this Agreement are herein described as occurring on the Effective Date, settlement hereunder shall occur in two phases, as follows:
 
(i)   Preliminary Settlement. Seller and Buyer will on the Effective Date conduct a preliminary settlement (the “Preliminary Settlement”) using preliminary data as of such date or dates (which dates shall not be more than ten (10) days prior to the Effective Date) as Buyer shall determine (including, without limitation, data from updated Schedules C and D). The Cash Payment shall be calculated based upon such preliminary data and the amount so calculated shall be paid by wire transfer of immediately available funds.
 
(ii)   Adjusting Settlement. After the final data necessary to prepare a definitive settlement sheet are available and within thirty (30) days after the Effective Date, Seller and Buyer shall meet for purposes of conducting an adjusting settlement (the “Adjusting Settlement”) using such final data. The difference between the amount of cash paid by Seller to Buyer at the Preliminary Settlement and the amount of the Cash Payment as determined at the Adjusting Settlement, together with interest accrued thereon from the Effective Date, at the federal funds rate in effect on the Effective Date, shall be paid by wire transfer of immediately available funds by Seller to Buyer or by Buyer to Seller, as the case may be.
 
-7-
1.5   Obligations of Seller on the Effective Date. On the Effective Date, Seller shall:
 
(a)   Physical Possession. Deliver to Buyer such of the Purchased Assets as shall be capable of physical delivery;
 
(b)   Documents of Transfer. Execute and deliver to Buyer a Bill of Sale in the form attached hereto as Exhibit C, an Assignment and Assumption Agreement in the form attached hereto as Exhibit D, a special warranty deed in the form attached hereto as Exhibit A, and all such endorsements, assignments or other instruments of conveyance, assignment and transfer as shall be reasonably necessary or advisable to consummate the sale and transfer to Buyer of the Purchased Assets and Assumed Liabilities in accordance with the terms of this Agreement;
 
(c)   Safe Deposit Boxes. Deliver to Buyer the keys, contracts, signature cards and other records relating to the Safe Deposit Box Business;
 
(d)   Updated Schedules. Deliver to Buyer Schedules C and D, updated as of the close of business on the last business day prior to the Effective Date;
 
(e)   Deposit Related Loans. Deliver to Buyer all notes (or, to the extent possible, an affidavit of lost note if Seller does not have possession of a note) relating to the Deposit Related Loans and all files and records relating to the Deposit Related Loans as exist and are available to Seller (it being understood and agreed that Seller shall have no obligation to deliver any document or instrument which is not in its possession on the Effective Date) and all collateral security of any nature whatsoever held by Seller as collateral security for each Deposit Related Loan;
 
(f)   Other Loans. Execute and deliver to Buyer the Loan Purchase Agreement, together with all such documents as are contemplated under the Loan Purchase Agreement;
 
(g)   Limited Power of Attorney or Confirmation of Officer Appointment. Deliver to Buyer, at Seller’s option: (i) a limited power of attorney granting to the employees of Buyer named therein (such employees to be designated by Buyer and approved by Seller) authority to endorse notes and execute assignments and other documents and instruments
 
-8-
sufficient to convey to Buyer the Deposit Related Loans, the Other Loans and all related collateral security, or (ii) confirmation that Seller has appointed as officers of Seller not more than three (3) employees of Buyer (such employees to be designated by Buyer and approved by Seller) for the limited purpose of permitting such employees to endorse notes and execute assignments and other documents and instruments sufficient to convey to Buyer the Deposit Related Loans, the Other Loans and all related collateral security;
 
(h)   Residual Processing Agreement. Execute and deliver to Buyer the Residual Processing Agreement (as defined in Section 4.13(e) below);
 
(i)   Deposit Records. Assign, transfer and deliver to Buyer such of the following records pertaining to the Assumed Deposits as exist and are available to Seller, it being understood and agreed that Seller shall have no obligation to deliver any document or instrument which is not in its possession on the Effective Date: (i) signature cards, (ii) orders and contracts between Seller and Branch depositors and records of similar character, to the extent that such orders, contracts and other records are available to Seller and can reasonably be retrieved from Seller’s records and transferred to Buyer, (iii) the form of rules and regulations applicable to the Branch, (iv) electronic data files containing a customer’s name, address, social security number, account type and balance, taxpayer identification number, and withholding information, and (v) electronic data files containing IRA information and data;
 
(j)   Cash Payment. Pay to Buyer the Cash Payment by wire transfer of immediately available funds;
 
(k)   Consents. Deliver to Buyer all consents necessary to permit this Agreement to be consummated without violation of any contract; and
 
(l)   Other Documents. Execute and deliver to Buyer all such other documents and instruments as Buyer may reasonably request.
 
1.6   Obligations of Buyer on the Effective Date. On the Effective Date, Buyer shall:
 
(a)   Assignment and Assumption Agreement. Execute and deliver to Seller a counterpart Assignment and Assumption Agreement;
 
-9-
(b)   Residual Processing Agreement. Execute and deliver to Seller the Residual Processing Agreement (as defined in Section 4.12(d) below);
 
(c)   Loan Purchase Agreement. Execute and deliver to Seller the Loan Purchase Agreement, together with all such documents as are contemplated under the Loan Purchase Agreement; and
 
(d)   Other Documents. Execute and deliver to Seller all such other documents and instruments as Seller may reasonably request.
 
1.7   Indemnification. 
 
(a)   Seller’s Indemnity Obligation. Except as otherwise provided herein, Seller shall indemnify, hold harmless and defend Buyer from and against all claims, losses, suits or causes of action, liabilities, expenses, costs, demands and obligations, including reasonable legal fees (collectively, the “Losses”), arising out of or relating to: (i) the conduct of business and operations at the Branch (including the Purchased Assets, Assumed Liabilities and employees) prior to the close of business on the Effective Date, including any act or omission of Seller prior to the close of business on the Effective Date relating to the Purchased Assets or the Assumed Liabilities; (ii) any liability of Seller which is not assumed by Buyer hereunder, (iii) any material breach of any representation or warranty made by Seller in this Agreement or in any certificate or other document delivered to Buyer hereunder, or (iv) any material breach of any covenant made by Seller in this Agreement or in any certificate or other document delivered to Buyer hereunder; provided, however, that this Section 1.7(a) shall not be applicable to the Loan Purchase Agreement, which sets forth the exclusive representations, warranties, covenants and remedies applicable to the Other Loans and to the transactions contemplated therein. Promptly after the receipt of notice of a Loss with respect to which Buyer will seek a defense, indemnification, reimbursement or other remedy under this Section, Buyer shall notify Seller in writing, setting forth in reasonable detail the basis therefor and providing copies of all relevant documents relating thereto. Seller shall then have thirty (30) days from the date it received such notice to investigate the Loss and determine whether it will elect to assume the defense of the matter. If it does so elect, Buyer shall give its full cooperation and assistance to Seller in maintaining a defense. Seller shall not be liable for any amounts paid in settlement of a Loss if
 
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such settlement is effected without Seller’s written consent, which consent shall not be unreasonably withheld. It is understood that the obligations of Seller under this Section shall survive the Effective Date to the extent provided in Section 1.7(c) below.
 
(b)   Buyer’s Indemnity Obligation. Buyer shall indemnify, hold harmless and defend Seller from and against all Losses arising out of or relating to: (i) the operation of the Branch after the close of business on the Effective Date, (ii) any act or omission of Buyer occurring after the close of business on the Effective Date relating to the Purchased Assets or the Assumed Liabilities, (iii) any liability assumed by Buyer under this Agreement, (iv) any material breach of any representation or warranty made by Buyer in this Agreement or in any certificate or other document delivered to Seller hereunder, or (v) any material breach of any covenant made by Buyer in this Agreement or in any certificate or other document delivered to Seller hereunder; provided, however, that this Section 1.7(b) shall not be applicable to the Loan Purchase Agreement, which sets forth the exclusive representations, warranties, covenants and remedies applicable to the Loans and to the transactions contemplated therein. Promptly after the receipt of notice of a Loss with respect to which Seller will seek a defense, indemnification, reimbursement or other remedy under this Section, Seller shall notify Buyer in writing, setting forth in reasonable detail the basis therefor and providing copies of all relevant documents relating thereto. Buyer shall then have thirty (30) days from the date it received such notice to investigate the Loss to determine whether it will elect to assume the defense of the matter. If it does so elect, Seller shall give its full cooperation and assistance to Buyer in maintaining a defense. Buyer shall not be liable for any amounts paid in settlement of a Loss if such settlement is effected without Buyer’s written consent, which consent shall not be unreasonably withheld. It is understood that the obligations of Buyer under this Section shall survive the Effective Date to the extent provided in Section 1.7(c) below.
 
(c)   Limitations on Liability.
 
(i)   Limitations on Liability of Seller. Seller shall not be liable for indemnification claims pursuant to Section 1.7(a)(iii) or (iv) above except to the extent that the aggregate Losses suffered or incurred by Buyer exceed $50,000.  In no event
 
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shall Seller’s liability to Buyer for indemnification pursuant to Section 1.7(a) exceed, in the aggregate, the amount of the Deposit Premium.
 
(ii)   Limitations on Liability of Buyer. Buyer shall not be liable for indemnification claims pursuant to Section 1.7(b)(iv) or (v) above except to the extent that the aggregate Losses suffered or incurred by Seller exceed $50,000. In no event shall Buyer’s liability to Seller for indemnification pursuant to Section 1.7(b) exceed, in the aggregate, the amount of the Deposit Premium.
 
(d)   Survival of Indemnity Obligations. All representations, warranties and covenants set forth in this Agreement shall survive the Closing, shall continue in effect for a period of 18 months after the Effective Date and all indemnity obligations hereunder shall thereafter terminate, except as to any claim for which written notice shall have been given prior to the expiration of such 18 month period; provided, however, that: (i) Seller’s obligation to indemnify Buyer under Section 1.7(a)(i) and (ii) above and Buyer’s obligation to indemnify Seller under Section 1.7(b)(i) through (iii) above shall not terminate upon the expiration of such 18 month period and shall remain in full force and effect indefinitely, and (ii) each other covenant or other agreement set forth herein which by its terms is to be performed after the expiration of such 18 month period shall survive until fully discharged.
 
(e)   Exclusive Remedy. Except for the right of a party to seek specific performance and other forms of equitable relief as contemplated under Section 7.7 below, a claim for indemnification pursuant to this Section 1.7 shall be the exclusive remedy available to either party with respect to any breach of any representation, warranty, covenant or other agreement by the other party (whether such claim arises under contract, tort or any other legal theory) and each party hereby waives any and all other rights and remedies which it may have against the other party at law or in equity arising from or relating to any such breach.
 
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ARTICLE II 
REPRESENTATIONS AND WARRANTIES OF SELLER
 
Seller represents and warrants to Buyer, as of the date of this Agreement and as of the Effective Date, as follows:
 
2.1   Corporate Organization and Standing. Seller is a national bank, duly organized, validly existing and in good standing under the laws of the United States of America, and has full power and lawful authority to own, lease and hold its properties and to carry on its present business.
 
2.2   Corporate Authority; Due Authorization; Execution and Delivery; Binding Obligation. Seller has the corporate power and authority to enter into this Agreement and, subject to the receipt of all required regulatory approvals and the giving of all required notices, to carry out its obligations hereunder. The execution and delivery of this Agreement and the performance of the transactions contemplated herein have been (or, prior to the Effective Date, will be) duly authorized by the Board of Directors of Seller, and no other corporate action on the part of Seller is necessary to authorize the execution and delivery of this Agreement or the performance of the transactions contemplated herein. This Agreement has been duly executed and delivered by Seller and (assuming due authorization, execution and delivery by Buyer) constitutes a legal, valid and binding obligation of Seller, enforceable against Seller in accordance with its terms, subject as to enforcement to bankruptcy, insolvency, reorganization, moratorium and similar laws affecting the enforceability of the rights of creditors generally and subject to the application of equitable principles.
 
2.3   No Violation. Subject to the receipt of all required regulatory approvals and third party consents and the giving of all required notices, the execution, delivery and performance of this Agreement will not constitute a violation of or a breach or default under the charter or the bylaws of Seller or any material statute, rule, regulation, order, judgment, decree, contract, note, mortgage, indenture, license, lease or other instrument or agreement to which Seller is a party or by which Seller or any of the Purchased Assets or Assumed Liabilities are bound, which breach, violation or default would have a material adverse effect upon: (i) the Purchased Assets, the
 
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Assumed Liabilities or the business conducted at the Branch, or (ii) the financial condition, business or results of operations of Seller and its subsidiaries taken as a whole.
 
2.4   Title to Assets. 
 
(a)   Real Estate. Seller, to the best of its knowledge, has good and marketable title to the Real Estate free and clear of all liens or encumbrances of any kind whatsoever, other than: (i) liens of current taxes not yet due, and (ii) such imperfections of title, encumbrances and easements, if any, as are not substantial in character, amount or extent and do not materially detract from the value or interfere with the present or proposed use thereof (which shall include existing visible easements and rights of municipalities and public utilities).
 
Seller has ordered a title commitment relating to the Real Estate from Fidelity National Title Insurance Company (the “Title Commitment”) and, upon receipt of the Title Commitment, shall promptly deliver a copy to Buyer. If any exception from coverage appears in the Title Commitment (other than an exception described in clause (i) or (ii) of the preceding paragraph) and if such exception is unacceptable to Buyer, Buyer shall identify each such exception (an “Exception”) in a written notice (an “Exception Notice”) to be delivered to Seller within fifteen (15) days after receipt by Buyer of the Title Commitment. (In the event that Buyer fails timely to notify Seller of Exceptions as required herein, Buyer shall be deemed to have waived any and all rights to object to the status of the title to the Real Estate.) Seller shall within fifteen (15) days following its receipt of an Exception Notice, deliver to Buyer a written notice (the “Seller Response”) setting forth with respect to each such Exception, at Seller’s option: (A) a legally binding undertaking on the part of Seller to cure such Exception by taking all such actions as may be necessary to cause _____ Title Insurance Company to remove such Exception from the title policy to be issued to Buyer, or (B) a statement that Seller has elected not to cure such Exception. In the event that Seller elects not to cure any Exception, Buyer may by written notice delivered to Seller within fifteen (15) days following Buyer’s receipt of the Seller Response elect to terminate this Agreement, in which case Buyer shall have no further rights or recourse with respect to the Branch or the related Purchased Assets or Assumed Liabilities. In the event that Buyer does not timely elect to terminate this Agreement as provided
 
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 in the preceding sentence, Buyer shall be deemed to have waived any and all rights to object to the Exception or Exceptions involved.
 
(b)   Other Purchased Assets. Seller is the owner of and has (and will at the Closing convey to Buyer) good and marketable title to the Purchased Assets (except that this representation and warranty does not apply to: (i) the Real Estate, the representations and warranties with respect to which are set forth exclusively in Section 2.4(a) above, and (ii) the Loans, the representations and warranties with respect to which are set forth exclusively in the Loan Purchase Agreement), free and clear of all liens and encumbrances of any kind whatsoever, other than such imperfections of title, encumbrances and easements, if any, as are not substantial in character, amount or extent and do not materially detract from the value or interfere with the present or proposed use thereof.
 
2.5   The Branch.
 
(a)   Legal Compliance. Seller represents and warrants to Buyer that: (i) there is no condemnation or similar proceeding pending or threatened which would preclude or materially impair the ability to use the Branch as such Branch is presently used by Seller in the conduct of its business, (ii) no notice of any proposed assessment against the Branch has been received by Seller from any governmental authority, and (iii) no notice has been received by Seller from any governmental authority that the Branch is in violation of the Americans with Disabilities Act (the “ADA”), or any asbestos abatement or Occupational Safety and Health Administration (“OSHA”) regulations, or any zoning law, building or fire code or similar statute, ordinance or regulation.
 
(b)   Condition of Branch. The structures and other improvements to the Real Estate are in good operating condition and repair, ordinary wear and tear excepted.
 
(c)   No Other Representations or Warranties. Except as expressly provided in Section 2.4(a) and in this Section 2.5, the Real Estate is being sold “as is, where is” and without representations or warranties of any kind.
 
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2.6   Environmental Matters. 
 
(a)   Phase I Examination. Buyer, if it wishes to have a Phase I environmental examination of the Real Estate and the improvements located thereon, shall within fifteen (15) days from the date hereof engage a competent engineering firm (which firm shall be subject to Seller’s approval, which will not be unreasonably withheld) for this purpose. The cost of such Phase I environmental examination shall be borne by Buyer. Upon receipt of the Phase I report (the “Phase I Report”), Buyer shall promptly (and, in any event, on or before September 30, 2006) deliver a copy to Seller. If anything appears in the Phase I Report which Buyer determines in the exercise of its reasonable judgment to involve potential remediation expense or other liability in excess of $25,000, Buyer shall identify each such item (an “Environmental Exception”) in a written notice (an “Exception Notice”) to be delivered to Seller with Seller’s copy of the Phase I Report. (In the event that Buyer fails timely to notify Seller of any Environmental Exceptions as required herein, Buyer shall be deemed to have waived any and all rights to object to the environmental condition of the Real Estate.) Seller shall within fifteen (15) days following its receipt of an Exception Notice, deliver to Buyer a written notice (the “Seller Response”) setting forth with respect to each such Environmental Exception, at Seller’s option: (a) a legally binding written undertaking on the part of Seller to remediate each such Environmental Exception by taking all such actions as may be necessary to effect such remediation in compliance with all applicable laws and in a manner reasonably acceptable to Buyer, which undertaking shall be reasonably satisfactory to Buyer in form and substance; or (b) a statement that Seller has elected not to remediate such Environmental Exception. In the event that Seller elects not to remediate any Environmental Exception, Buyer may by written notice delivered to Seller within fifteen (15) days following Buyer’s receipt of the Seller Response elect to terminate this Agreement, in which case Buyer shall have no further rights or recourse with respect to the Branch or the related Purchased Assets or Assumed Liabilities. In the event that Buyer does not timely elect to terminate this Agreement as provided in the preceding sentence, Buyer shall be deemed to have waived any and all rights to object to the Environmental Exception or Exceptions involved.
 
(b)   Representations. As of the date of this Agreement, to the knowledge of Seller: (i) the Real Estate is not in violation of or liable under any environmental law (as
 
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herenafter defined); (ii) there are no threatened or outstanding actions, suits, proceedings or investigations, or demands, claims or notices, including, without limitation, notices, demand letters or requests for information from any regulatory authority, with respect to the Real Estate which involve or relate to any Environmental Law; and (iii) the Real Estate has not been listed or proposed for listing on the National Priority List under the Comprehensive Environmental Response, Compensation and Liability Act, as amended (“CERCLA”), on the Comprehensive Environmental Response Compensation and Liabilities Information System or on any similar state list. For purposes of this Agreement, the term “Environmental Law” shall mean any federal, state or local law, statute, ordinance, rule or regulation, relating to: (x) the protection, preservation or restoration of the environment (including, without limitation, air, water, vapor, surface water, groundwater, drinking water supply, surface soil, subsurface soil, plant and animal life or any other natural resource), or (y) the use, storage, recycling, treatment, generation, transportation, processing, handling, labeling, production, release or disposal of hazardous or toxic substances.
 
2.7   Other Representations and Warranties.
 
(a)   Assumed Deposits. The Assumed Deposits have been originated and administered and are in compliance in all material respects with all applicable federal and state laws and regulations and in compliance with the agreements and terms governing such deposits and are insured by the FDIC to the maximum extent permitted by law.
 
(b)   Interest Rates. The interest rates paid by the Seller on the Assumed Deposits during the six month period preceding the date of this Agreement were established in the ordinary course, consistent with past practice, and were consistent with the rates then offered by Seller at its other branches.
 
(c)   No Litigation. There is no civil, criminal or administrative investigation, action, suit or proceeding pending or, to the knowledge of Seller, threatened, against Seller which, if determined adversely to Seller, would materially adversely affect the Purchased Assets or Assumed Liabilities taken as a whole or which would materially adversely affect the validity of this Agreement.
 
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2.8   No Broker. Seller has not retained any broker, finder or other intermediary who is or would be entitled to be paid any fee, commission or other compensation for, on account of, or in connection with the transactions contemplated by this Agreement, except for Cedar Hill Advisors, LLC, whose fee is to be paid entirely by Seller.
 
2.9   No Other Warranties. Except as expressly provided in this Article II or in the Loan Purchase Agreement, the Purchased Assets and the Assumed Liabilities shall be sold and assigned to Buyer “AS IS, WHERE IS,” without recourse and without any warranties whatsoever, express or implied, including, without limitation, warranties with respect to title, condition, enforceability, collectibility, documentation or freedom from liens or encumbrances.
 
ARTICLE III
REPRESENTATIONS AND WARRANTIES OF BUYER
 
Buyer represents and warrants to Seller, as of the date of this Agreement and as of the Effective Date, as follows:
 
3.1   Corporate Organization and Standing. Buyer is a national bank, duly organized, validly existing and in good standing under the laws of the United States, and has full power and lawful authority (including all required regulatory approvals and authorizations) to own, lease and hold its properties and to carry on its present business.
 
3.2   Corporate Authority; Due Authorization; Execution and Delivery; Binding Obligation. Buyer has the corporate power and authority to enter into this Agreement and, subject to the receipt of all required regulatory approvals, to carry out its obligations hereunder. The execution and delivery of this Agreement and the performance of the transactions contemplated herein have been (or, prior to the Effective Date, will be) duly authorized by the Board of Directors of Buyer and no other corporate action on the part of Buyer is necessary to authorize the execution and delivery of this Agreement or the performance of the transactions contemplated herein. This Agreement has been duly executed and delivered by Buyer and (assuming due authorization, execution and delivery by Seller) constitutes a legal, valid and binding obligation of Buyer, enforceable against Buyer in accordance with its terms, subject as to enforcement to bankruptcy, insolvency, reorganization, moratorium and similar laws affecting
 
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the enforceability of the rights of creditors generally and subject to the application of equitable principles.
 
3.3   No Violation. Subject to the receipt of all required regulatory approvals, the execution, delivery and performance of this Agreement will not constitute a violation of or breach or default under the Articles of Incorporation or the bylaws of Buyer or any material statute, rule, regulation, order, judgment, decree, contract, note, mortgage, indenture, license, lease or other instrument or agreement to which Buyer is a party or by which Buyer or any of its assets are bound.
 
3.4   No Broker. Buyer has not retained any broker, finder or other intermediary who is or would be entitled to be paid any fee, commission or other compensation for, on account of, or in connection with the transactions contemplated by this Agreement.
 
ARTICLE IV
OBLIGATIONS OF THE PARTIES PRIOR TO AND AFTER EFFECTIVE DATE
 
4.1   Cooperation and Best Efforts. Buyer and Seller shall each cooperate with the other, and each shall use its commercially reasonable best efforts to do or cause to be done all things necessary or appropriate on its part in order to effect the consummation of this Agreement and the Loan Purchase Agreement; provided, however, that Seller shall not be obligated to pay any money or other consideration to or initiate any suit or proceeding against any third party in order to obtain any waiver or consent which may be required in connection with the transfer or conveyance of any Purchased Asset. Without limitation of the foregoing, the parties shall cooperate with one another and each shall take all such commercially reasonable actions as may be necessary and as are consistent with customary industry practices in order to assure that the Closing and transition (including the conversion of Seller’s data relating to the Assumed Deposits and the Loans) are effected smoothly and efficiently so as to minimize potential disruption to the customers of the Branch, to Buyer and to Seller.
 
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4.2   Conduct of Business.
 
Pending the Effective Date, and except as otherwise consented to by Buyer:
 
(a)   Ordinary Course. Seller shall carry on the business of the Branch diligently and substantially in the same manner as carried on as of the date hereof and Seller will not, with regard to the Branch, engage in any one or more activities or transactions which shall be outside of the ordinary course of the business of the Branch as conducted as of the date hereof, except for activities or transactions contemplated by this Agreement.
 
(b)   Preservation of Business. Seller shall use its commercially reasonable efforts to preserve its business operations as conducted at the Branch intact. Seller further agrees to use its commercially reasonable efforts to preserve for Buyer the goodwill of its customers and others having relations with the business normally conducted at the Branch and to cooperate with and assist Buyer in assuring the orderly transition of such business from Seller to Buyer.
 
(c)   Interest Rates. Without limitation of the foregoing, Seller agrees that the interest rates offered by it on the Deposit Liabilities and the Loans shall be established in the ordinary course consistent with past practice and shall be consistent with the rates offered by Seller at its other Branches.
 
4.3   Access to Records and Properties. Seller shall afford to the officers and authorized representatives of Buyer access to the Branch and to the books and records in Seller’s possession relating to the Purchased Assets and Assumed Liabilities in order that Buyer may have an opportunity to make such reasonable investigations thereof at such reasonable times as it may from time to time reasonably request, and Seller shall furnish Buyer with such additional financial and operating data and other information relating to its business and properties at the Branch and to the Purchased Assets and Assumed Liabilities as Buyer may from time to time reasonably request, including information required for inclusion in the regulatory applications required to be filed by Buyer pursuant to Section 4.5 below. Buyer’s access to Seller’s properties shall be subject to Seller’s normal security procedures. Nothing in this Section shall be deemed to require Seller to breach any obligation of confidentiality.
 
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4.4   Seller Regulatory Applications. Seller shall, on or before August 15, 2006, prepare and file all required notices (if any) and all required applications for regulatory approval of the transactions (if any) contemplated by this Agreement and shall use its commercially reasonable best efforts to obtain all such approvals.
 
4.5   Buyer Regulatory Applications. Buyer shall promptly prepare and file all required applications for regulatory approval of the transactions contemplated by this Agreement and shall use its commercially reasonable best efforts to obtain all such approvals (the “Buyer Regulatory Approvals”).
 
4.6   Employee Matters.
 
(a)   Retention of Seller Employees. Buyer agrees on the Effective Date to extend an offer of employment to each person then employed by Seller at the Branches (or on approved leave therefrom) at a base salary or wage which is not less than that in effect as of the day immediately preceding Effective Date and Buyer further agrees not to reduce such base salary or wage for a period of twelve (12) months after the Effective Date. Seller agrees in this regard that it will not increase the compensation of any such Branch Employee after the date hereof, except in the ordinary course consistent with past practice and that it will consult with Buyer prior to implementing any such increase. Seller also agrees that such increases, in the aggregate, shall not exceed seven percent (7%) of current compensation for employees eligible for a raise through December 31, 2006. Buyer agrees that if, within twelve (12) months after the Effective Date, it terminates (other than for cause, as determined by Buyer in its reasonable discretion) the employment of any person who accepts Buyer’s offer of employment pursuant to this Section 4.6(a) (a “Transferred Employee”), Buyer shall pay to such Transferred Employee the severance benefit as described in Schedule F, giving such Transferred Employee past service credit based upon such Transferred Employee’s hire date with Seller (or upon such Transferred Employee’s hire date by any predecessor of Seller acquired by Seller through merger, purchase of assets or otherwise, where Seller has granted past service credit to such Transferred Employee), subject to the condition that the Transferred Employee execute and deliver to Seller and to Buyer a complete waiver and release of claims in favor of Seller and Buyer in a form acceptable to Seller and to Buyer. If within twelve (12) months after the Effective Date:
 
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 (i) Buyer involuntarily transfers any Transferred Employee to a location other than the Branch and if the distance between such location and the Branch is more than thirty (30) miles, (ii) Buyer reduces the base salary or wages of any Transferred Employee, or (iii) Buyer materially changes the duties or schedule of any Transferred Employee, and such Transferred Employee declines the transfer, reduction in base salary or wages or material change in schedule or duties and is terminated by Buyer as a result, then Buyer shall pay to such Transferred Employee the severance benefit described in Schedule F, with past service credit determined as set forth above. Seller will recommend that Branch employees accept Buyer’s offer of employment and will provide to Buyer such assistance as Buyer may reasonably request in connection with Buyer’s solicitation of the Branch employees.
 
(b)   Past Service Credit. With respect to Buyer’s employee retirement and welfare benefit plans (as defined in the Employee Retirement Income Security Act of 1974, as amended), Buyer agrees to provide to each Transferred Employee past service credit for purposes of eligibility to participate and vesting only (excluding past service credit for benefit accrual purposes), based upon such Transferred Employee’s hire date with Seller (or upon such Transferred Employee’s hire date by any predecessor of Seller acquired by Seller through merger, purchase of assets or otherwise, where Seller has granted past service credit to such Transferred Employee). With respect to Buyer’s vacation and sick leave policies and Buyer’s employee discount programs (such as loans, mortgages, deposit accounts, and ATM and credit cards) and for purposes of the Family and Medical Leave Act, Buyer agrees to provide to each Transferred Employee past service credit (determined as set forth above) for purposes of benefit and leave entitlement.
 
(c)   Communications with Employees. Buyer and Seller shall mutually agree as to the scope and content of all communications to the employees at the Branch who are to be offered employment pursuant to Section 4.6(a) above. In no event shall Buyer contact any such employee without the prior consent of Seller, which consent shall not be unreasonably withheld.
 
(d)   Employee Training. At mutually agreed upon times following the date hereof, Buyer shall be permitted to meet with the employees at the Branch to discuss employment opportunities with Buyer, provided that representatives of Seller shall be permitted
 
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to attend any such meeting. From and after the date on which Buyer has obtained all required regulatory approvals, Buyer shall also be permitted to conduct training sessions for Branch employees outside of normal business hours or at other times as Seller may approve and may, with Seller’s consent (which shall not be unreasonably withheld), conduct such training sessions at the Branch; provided that Buyer will in good faith attempt to schedule such training sessions in a manner which does not unreasonably interfere with Seller’s normal business operations. Buyer shall reimburse the employees for transportation costs to and from the locations where Buyer conducts such training, and Buyer shall compensate the employees (or reimburse Seller) at each employee’s applicable standard or overtime rate for the time spent by such employee in such training and, in the case of non exempt employees, for travel time to the extent required by law.
 
(e)   Transferred Employee Records. Seller shall have no duty or obligation to deliver to Buyer personnel or medical records relating to any Transferred Employee, but shall provide to Buyer only such information as may be reasonably necessary to permit Buyer to make provision for providing the Transferred Employee and, as applicable, the Transferred Employee’s dependents, with welfare and pension plan coverage as described in Section 4.6(b) above.
 
(f)   Employee Information Returns. Seller shall, at its expense, prepare and forward to all applicable taxing authorities and to each employee who becomes a Transferred Employee all required federal and state income tax information returns (including, without limitation, Form W-2) for the period from January 1, 2006 through the day prior to the Effective Date. Buyer shall, at its expense, prepare and forward to all applicable taxing authorities and to each employee who becomes a Transferred Employee all required federal and state income tax information returns (including, without limitation, Form W-2) for all periods beginning on and after the Effective Date.
 
4.7   Public Announcements and Customer Notices. Buyer and Seller will consult with one another before issuing any press release or otherwise making any public statements or customer notifications with respect to this Agreement and the transactions contemplated hereby and agree that, unless approved by the other party hereto in advance, neither Buyer nor Seller
 
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shall issue any such press release or make any such public statement or customer notification prior to such consultation, except as may be required by law. In the event that any notice to Branch customers may be required by law or by deposit contract, the party required to give such notice shall: (i) provide the other party a copy of the notice at least seven (7) calendar days prior to the proposed mailing date for approval by the other party, which approval shall not be unreasonably withheld and which shall be provided no later than two (2) calendar days after receipt of such notice, and (ii) timely give the notice at that party’s sole expense and provide the other party with a copy of the final notice. In no event shall Buyer send any customer notifications prior to obtaining all Buyer Regulatory Approvals.
 
4.8   Prohibition Against Certain Disclosures. In the event that Buyer should decide prior to the Effective Date to relocate, consolidate or close the Branch or to change the terms and conditions of any deposit account, Buyer covenants and agrees that it will not announce or otherwise publicly disclose any such decision or the fact that the relocation, consolidation or closing of the Branch or change in the terms and conditions of any deposit account is under consideration (whether such announcement or other public disclosure is by press release, by notice to a regulator in a publicly available filing, by published legal notice, by posting of a notice in the Branch, by a mailing to customers of the Branch, or otherwise) at any time before the Effective Date.
 
4.9   Prohibition Against Customer and Employee Solicitations.
 
(a)   Non Solicitation of Customers by Buyer. Buyer shall not during the period from the date of this Agreement until the Effective Date solicit any customer of the Branch for the purpose of inducing any such customer to: (i) open a deposit account with Buyer or to transfer all or any part of any Deposit Liability to any then existing deposit account with Buyer, (ii) apply for or obtain any loan with Buyer, or (iii) establish any other relationship with Buyer; provided, however, that Buyer shall not be prohibited from engaging in advertising and marketing activities consistent with past practice which are directed to the public generally and which are not specifically targeted at any customer or customers of the Branch.
 
(b)   Non Solicitation of Employees by Buyer. Buyer shall not during the period from the date of this Agreement until the Effective Date solicit for employment, engage as
 
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an independent contractor or consultant, or otherwise induce to terminate his employment relationship with Seller any person who is now or may at any time prior to the Effective Date be employed by Seller at the Branch.
 
4.10   IRA and Keogh Accounts. Seller, in its capacity as trustee of any Assumed Deposits which are IRA or Keogh deposits, shall to the extent legally permissible resign as trustee of such IRA and Keogh deposits and Seller shall appoint Buyer as successor trustee or custodian effective as of the Effective Date and Buyer shall accept such appointment.
 
4.11   Buyer Account Forms and ATM/Debit Cards.
 
(a)   Buyer Account Forms. Buyer shall, promptly following the receipt by it of all Buyer Regulatory Approvals, but no later than five (5) days prior to the Effective Date, at its expense, forward to each customer whose deposit account will be assumed by Buyer, by first class mail, checks, deposit tickets, or other similar instruments on Buyer’s forms which shall be appropriately encoded with Buyer’s routing number and with accurate account numbers, and with instructions to the customer to utilize such checks, deposit tickets, and other similar instruments on and after the Effective Date and thereafter to destroy any unused checks on Seller’s forms.
 
(b)   Buyer ATM/Debit Cards. Buyer shall, following the receipt by it of all Buyer Regulatory Approvals, but no later than five (5) days prior to the Effective Date, forward to each customer whose deposit account will be assumed by Buyer, by first class mail, Buyer ATM/Debit cards to replace Seller’s ATM/Debit cards, together with a notice advising such customer to destroy Seller’s ATM/Debit cards, such notice to be reasonably acceptable to Seller in form and substance. Seller shall undertake reasonable operational measures and such other actions as may reasonably be requested by Buyer to provide existing personal identification numbers of such customers in encrypted format to Buyer not later than five (5) Business Days prior to the Effective Date.
 
(c)   Deactivation of Seller’s ATM’s and ATM/Debit Cards. On the Effective Date, Seller shall deactivate the ATM/Debit cards issued by it to each customer whose deposit account is assumed by Buyer, shall electronically block access of such cards to such accounts,
 
-25-
and shall deactivate the ATM’s to be acquired by Buyer at a time to be mutually agreed upon by the parties which is not earlier than 5:00 p.m. on the Effective Date and not later than 8:00 a.m. on the Monday next following the Effective Date.
 
4.12   Cooperation and Further Assurances; Correction of Errors. The parties hereby covenant and agree to cooperate with one another after the Effective Date in order to effectuate the purposes of this Agreement. Without limitation of the foregoing:
 
(a)   Correction of Errors. Errors in calculation or data entry relating to the Assumed Deposits, the Loans, the transition obligations of the parties under Section 4.13 or otherwise which are discovered by a party may be corrected by notice given to the other party promptly after discovery of the error. Provided that it agrees that such an error occurred, the recipient of such notice shall take any action, including the payment of money or the amendment of any records, reasonably necessary to effect such correction within ten (10) business days after receiving such notice from the other party.
 
(b)   Further Documents of Transfer. Each party covenants and agrees, upon the reasonable request of the other and without further consideration, to execute and deliver such further instruments of conveyance, assignment and transfer and to take all such other actions as the other may from time to time reasonably request in order to effectuate the purposes of this Agreement.
 
4.13   Certain Transitional Matters.
 
Following the Effective Date:
 
(a)   Payment of Checks, Drafts and Withdrawal Orders. Buyer agrees to pay in accordance with law up to the collected amount on deposit (and any other funds available by reason of any agreement between the depositor and Seller which is assigned to Buyer) all properly drawn and presented checks, drafts and withdrawal orders presented to Buyer by mail, over its counters, through the check clearing system of the banking industry, or through the Federal Reserve Bank Automated Clearing House (“ACH”), by depositors of the accounts assumed, whether drawn on the checks, withdrawal or draft forms provided by Seller, or by Buyer, and in all other respects to discharge, in the usual course of the banking business, the
 
-26-
duties and obligations of Seller with respect to the balances due and owing to the depositors whose accounts are assumed by Buyer. Buyer’s obligation under this Section to honor checks, withdrawal or draft forms provided by Seller and carrying its imprint shall expire at the close of business on the 60th calendar day following the Effective Date. Buyer’s obligation under this Section to honor ACH items (debit and credit) shall expire on the close of business on the 60th calendar day following the Effective Date.
 
(b)   Deposit Accounts. If any of such depositors, instead of accepting the obligation of Buyer to pay the deposit liabilities assumed, shall demand payment from Seller for all or any part of any such assumed deposit liabilities, Seller shall not be liable or responsible for making such payment. Seller may, at its discretion, assume custody of such check or other item presented for payment on an account which has been transferred with the Branch, batch such items and forward them to Buyer on the next banking day after receipt by Seller at such location as Buyer may direct in writing. Seller shall not, at any time, be liable or responsible for making payment on such items by reason of its obtaining custody of them for transmittal to Buyer.
 
(c)   Uncollected Items. Buyer agrees, no later than the third business day after demand by Seller, to pay Seller an amount equivalent to the amount of any uncollected item included in a depositor’s balance on the Effective Date which is returned after the Effective Date as not collected.
 
(d)   Returned Deposit Related Loan Payments. If the balance due on any Deposit Related Loan has been reduced by Seller as a result of a payment by check received prior to the Effective Date, which item is returned after the Effective Date as uncollected, the asset value represented by the loan transferred shall be correspondingly increased and an amount in cash equal to such increase shall be paid by Buyer to Seller upon demand.
 
(e)   Residual Processing Agreement. Buyer and Seller agree that residual processing after the Effective Date will be in accordance with the Residual Processing Agreement attached hereto as Exhibit E (the “Residual Processing Agreement”).
 
4.14   Buyer Obligation to Maintain Records. Buyer agrees that it will preserve and safely keep all of the records and files delivered to it by Seller hereunder for the joint benefit of
 
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itself and Seller for such period as may be required by applicable law. Buyer further agrees that it will permit Seller and its authorized representatives, upon prior notice, at any reasonable time or times and at Seller’s expense, to inspect, take extracts from or copies of any such records and files as Seller shall deem reasonably necessary, subject to any customer privacy restrictions under applicable law as may now or hereafter exist.
 
4.15   Seller Obligation to Maintain Records. Seller agrees that it will preserve and safely keep, for as long as may be required by applicable law, all of the books and records of account (if any) not transferred to Buyer hereunder which relate to the Loans and the Assumed Deposits for the joint benefit of itself and Buyer. Seller further agrees that it will permit Buyer and its authorized representatives, upon prior written notice, at any reasonable time or times and at Buyer’s expense, to inspect, make extracts or copies of any such books and records of account as Buyer shall deem reasonably necessary, subject to any customer privacy restrictions under applicable law as may now or hereafter exist. 
 
4.16   Seller Restrictive Covenants.
 
(a)   Non Solicitation of Customers. Seller agrees that it will not, for a period of one (1) year following the Effective Date, directly solicit customers whose loans are purchased or whose deposit accounts are assigned to Buyer hereunder, except as may occur in connection with advertising or solicitations directed to the public generally. Nothing in this Section shall prevent Seller from forwarding any notice required by any government agency or by any law, rule or regulation.
 
(b)   Non Solicitation of Employees. Seller agrees that it will not, directly or indirectly, for a period of one (1) year following the Effective Date, solicit for employment, recruit, hire, cause to be hired, engage as an independent contractor or consultant or otherwise induce to terminate his employment relationship with Buyer any Transferred Employee; provided, however, that the foregoing covenant shall not apply to any Transferred Employee if: (i) such Transferred Employee is terminated by Buyer for any reason, or (ii) such Transferred Employee is hired or engaged by Seller as a result of a general solicitation for employment in newspaper advertisements or otherwise which is not specifically targeted at the Transferred Employees.
 
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(c)   Restriction on New Branch. Seller agrees that it will not for a period of two (2) years following the Effective Date establish or acquire a retail banking branch, mortgage office or loan production office in Wayne County, Pennsylvania; provided, however, that the foregoing limitation will not preclude Seller from acquiring (and subsequently operating) a retail banking branch or mortgage office or loan production office within Wayne County, Pennsylvania pursuant to the acquisition by merger, purchase of assets or otherwise of: (i) another bank or other financial institution, or (ii) any substantial part of the assets of another bank or other financial institution. Notwithstanding the foregoing, Seller agrees that it will not for a period of one (1) year following the Effective Date acquire any bank, bank holding company or other financial institution which has its headquarters in Wayne County, Pennsylvania and which operates one or more retail banking branches, mortgage offices or loan production offices in Wayne County, Pennsylvania.
 
4.17   Information Returns. Seller shall, at its expense, prepare and forward to all applicable taxing authorities and to all customers who are holders of Assumed Deposits or borrowers under the Loans all required federal and state income tax information returns (including, without limitation, Forms 1096, 1098 and 1099) for the period from January 1, 2006 through and including the Effective Date. Buyer shall, at its expense, prepare and forward to all applicable taxing authorities and to all customers who are holders of Assumed Deposits or borrowers under the Loans required federal and state income tax information returns (including, without limitation, Forms 1096, 1098 and 1099) for all periods after the Effective Date.
 
4.18   Casualty. In the event that any item of Furniture, Fixtures and Equipment is damaged or destroyed prior to the Effective Date by fire or other casualty and if Seller has not replaced such item with a comparable item, Buyer may, at its option, decline to purchase such damaged or destroyed item or accept the insurance proceeds paid or payable to Seller in respect of such damaged or destroyed item. In the event that the Branch is damaged or destroyed by fire or other casualty prior to the Effective Date, Seller shall apply the insurance proceeds paid in respect of such damage or destruction toward the repair of the Branch. In the further event that such repairs are not completed prior to the Effective Date, Buyer shall be entitled to receive all such insurance proceeds (except to the extent applied by Seller toward repair of the Branch) and Seller shall assign to Buyer and Buyer shall assume all of Seller’s obligations under all contracts
 
-29-
entered into by Seller in connection with such repairs. Seller covenants in this connection that it will maintain fire insurance on the Branch on a replacement cost basis at all times prior to the Effective Date.
 
ARTICLE V
CONDITIONS PRECEDENT
 
5.1   Conditions Precedent to Buyer’s Obligations. The obligation of Buyer to consummate this Agreement shall be subject to the satisfaction of each of the following conditions as of the Effective Date, except to the extent that any such condition may have been waived:
 
(a)   Accuracy of Representations and Warranties. All of the representations and warranties of Seller as set forth in this Agreement shall be true and correct in all material respects as of the Effective Date, as if made on such date (or on the date to which it relates in the case of any representation or warranty which expressly relates to an earlier date).
 
(b)   Covenants Performed. Seller shall have performed or complied in all material respects with all covenants required by this Agreement to be performed or complied with by it.
 
(c)   Regulatory Approvals. The approval of each federal and state regulatory authority having jurisdiction over the transactions contemplated by this Agreement shall have been obtained and all applicable waiting and notice periods shall have expired.
 
(d)   Consents. All consents required to be obtained by Seller from third parties in order to permit this Agreement to be consummated without violation of any contract shall have been obtained on terms and conditions reasonably satisfactory to Buyer.
 
(e)   No Litigation. No action, suit or proceeding shall be pending or threatened before any court or governmental agency which seeks to modify, enjoin or prohibit the transactions contemplated by this Agreement. No action, suit or proceeding shall be pending or threatened against either party which might: (i) materially adversely affect the Purchased Assets, the Assumed Liabilities or the business conducted at the Branch, or (ii) otherwise materially adversely affect this transaction.
 
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(f)   Deliveries by Seller. Seller shall have made to Buyer the deliveries specified in Section 1.5 of this Agreement.
 
(g)   Loan Purchase Agreement. The transactions contemplated under the Loan Purchase Agreement shall have closed and Seller shall have otherwise performed or complied in all material ways with all covenants required by the Loan Purchase Agreement to be performed or complied with by it.
 
(h)   Real Estate. Seller shall have conveyed to Buyer good and marketable fee simple title to the Real Estate, insurable at ordinary rates by Fidelity National Title Insurance Company (or by another nationally recognized title company), free and clear of all liens and encumbrances of any kind whatsoever, other than liens and encumbrances: (i) of the kind described in Clauses (i) and (ii) of Section 2.4(a) above, or (ii) relating to an Exception which Buyer shall be deemed to have waived pursuant to the last sentence of the second paragraph of Section 2.4 (a) above.
 
5.2   Conditions Precedent to Seller’s Obligations. The obligation of Seller to consummate this Agreement shall be subject to the satisfaction of each of the following conditions as of the Effective Date, except to the extent that any such condition may have been waived:
 
(a)   Accuracy of Representations and Warranties. All of the representations and warranties of Buyer as set forth in this Agreement shall be true and correct in all material respects as of the Effective Date, as if made on such date (or on the date to which it relates in the case of any representation or warranty which expressly relates to an earlier date).
 
(b)   Covenants Performed. Buyer shall have performed or complied in all material respects with all covenants required by this Agreement to be performed or complied with by it.
 
(c)   Regulatory Approvals. All required regulatory notices shall have been given, the approval of each federal and state regulatory authority having jurisdiction over the transactions contemplated by this Agreement shall have been obtained and all applicable waiting and notice periods shall have expired.
 
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(d)   Consents. All consents required to be obtained by Seller from third parties in order to permit this Agreement to be consummated without violation of any contract shall have been obtained on terms and conditions reasonably satisfactory to Seller.
 
(e)   No Litigation. No action, suit or proceeding shall be pending or threatened before any court or governmental agency which seeks to modify, enjoin or prohibit the transactions contemplated by this Agreement. No action, suit or proceeding shall be pending or threatened against either party which might: (i) materially adversely affect the Purchased Assets, the Assumed Liabilities or the business conducted at the Branch, or (ii) otherwise materially adversely affect this transaction.
 
(f)   Deliveries by Buyer. Buyer shall have made to Seller the deliveries specified in Section 1.6 of this Agreement.
 
(g)   Loan Purchase Agreement. The transactions contemplated under the Loan Purchase Agreement shall have closed and Buyer shall have otherwise performed or complied in all material ways with all covenants required by the Loan Purchase Agreement to be performed or complied with by it.
 
ARTICLE VI
TERMINATION, AMENDMENT AND WAIVER
 
6.1   Termination. This Agreement may be terminated at any time before the Effective Date, as follows:
 
(a)   Mutual Consent. This Agreement may be terminated at any time by mutual consent of the parties upon the execution by both parties of a written instrument to this effect.
 
(b)   Unilateral Action by Buyer. This Agreement may be terminated unilaterally by Buyer upon written notice given to Seller:
 
(i)   Breach. In the event that there has been a material breach by Seller of any representation, warranty or covenant set forth in this Agreement and such breach, if
 
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susceptible to cure, shall not have been waived or cured within 15 days after such notice is given;
 
(ii)   Regulatory Disapproval. In the event that any application required for regulatory approval of the transactions contemplated by this Agreement shall have been denied and the time period for appeals and requests for reconsideration shall have run;
 
(iii)   Failure of Condition. In the event that it is probable to a reasonable degree of certainty that, through no fault on the part of Buyer, a condition to Buyer’s obligations hereunder will not be satisfied prior to January 31, 2007;
 
(iv)   Failure to Close. In the event that the Effective Date shall not have occurred on or before the close of business on January 31, 2007, unless the failure of such occurrence is due to the wrongful failure of Buyer to perform its obligations under this Agreement;
 
(v)   Title Issues. In accordance with the second paragraph of Section 2.4(a) above; or
 
(vi)   Environmental Issues. In accordance with Section 2.6 above.
 
(c)   Unilateral Action by Seller. This Agreement may be terminated unilaterally by Seller upon written notice given to Buyer:
 
(i)   Breach. In the event that there has been a material breach by Buyer of any representation, warranty or covenant set forth in this Agreement and such breach, if susceptible to cure, shall not have been waived or cured within 15 days after such notice is given;
 
(ii)   Regulatory Disapproval. In the event that any application required for regulatory approval of the transactions contemplated by this Agreement shall have been denied and the time period for appeals and requests for reconsideration shall have run;
 
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(iii)   Failure of Condition. In the event that it is probable to a reasonable degree of certainty that, through no fault on the part of Seller, a condition to Seller’s obligations hereunder will not be satisfied prior to January 31, 2007; or
 
(iv)   Failure to Close. In the event that the Effective Date shall not have occurred on or before the close of business on January 31, 2007, unless the failure of such occurrence is due to the wrongful failure of Seller to perform its obligations under this Agreement.
 
6.2   Procedure Upon Termination. In the event that this Agreement is terminated as provided above:
 
(a)   Return of Documents. Each party shall return to the other all documents, work papers and other materials of the other party relating to this Agreement, whether obtained before or after the execution hereof.
 
(b)   Confidentiality. Neither party shall use for any business purpose or disclose to any third party any non-public information obtained by it during the course of its investigation of the other party, except to the extent judicially ordered or otherwise required by law to do so.
 
6.3   Effect of Termination. 
 
(a)   General. The termination of this Agreement shall not release or be construed to release either party from liability to the other arising out of or relating to any breach by such other party of any representation, warranty or covenant set forth in this Agreement.
 
(b)   Payment of Expenses. In the event that this Agreement is duly terminated by Buyer pursuant to Section 6.1(b)(i) above or by Seller pursuant to Section 6.1(c)(i) above, then in addition to such other rights the terminating party may have, the other party shall be obligated upon demand to pay all of the expenses reasonably incurred by the terminating party in connection with this Agreement, including but not limited to reasonable legal and accounting fees.
 
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6.4   Amendment. This Agreement may be amended at any time before the Effective Date by written instrument duly authorized and executed by Buyer and by Seller.
 
6.5   Waiver. Any term or condition of this Agreement may be waived by the party entitled to the benefit thereof at any time before the Effective Date by written instrument duly authorized and executed by such party and delivered to the other party.
 
ARTICLE VII
MISCELLANEOUS PROVISIONS
 
7.1   Parties in Interest and Assignment. This Agreement shall be binding upon and inure to the benefit of the parties hereto and to their respective successors and permitted assigns; provided, however, that the rights and obligations of Buyer under this Agreement may not be assigned by it without the prior written consent of Seller; provided, further, that this Agreement is not intended to confer upon any person not a party hereto or an assignee hereof, any rights or remedies of any kind and no such person (including, without limitation, any employee or customer of Seller) shall have any right to initiate or maintain any suit or action for any breach or alleged breach of this Agreement or to enforce any provision set forth herein.
 
7.2   Expenses. Each party hereto shall bear and pay all costs and expenses incurred by it or on its behalf in connection with the transactions contemplated herein, except that: (i) Buyer shall bear and pay all costs and expenses relating to the transfer of the Deposit Related Loans and Other Loans, including, but not limited to, the costs and expenses of preparing, executing, filing, and/or recording all assignments of mortgage and other collateral security, financing statements and other documents and instruments, and similar costs and expenses, and (ii) in the event that this Agreement is terminated by reason of a material breach, the breaching party shall pay certain expenses incurred by the terminating party as provided in Section 6.3(b) above. Without limitation of the foregoing, any expenses, fees and costs relating to applications for regulatory approval or to notices to customers of Seller provided for in this Agreement shall be borne by the party seeking such approval or giving such notice.
 
7.3   Notices. All notices, requests, demands, consents and other communications provided for hereunder shall be in writing and shall be hand delivered, mailed (by registered or
 
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certified mail) or telecopied with confirmation of receipt to a party at its address as it appears below:
 
If to Seller:
Michael B. High
Executive Vice President and Chief Operating Officer
Harleysville National Bank and Trust Company
483 Main Street
Harleysville, PA 19438
Facsimile: (215) 256-1931

with a copy to:
Clinton W. Kemp, Esquire
Stevens & Lee
25 North Queen Street, Suite 602
P.O. Box 1594
Lancaster, PA 17608-1594 [17603 for courier purposes]
Facsimile: (610) 236-4177
and


If to Buyer:
William S. Lance
First Senior Vice President
First National Community Bank
102 East Drinker Street
Dunmore, PA 18512-2491
Facsimile: (570) 348-6449

with a copy to:
Nicholas Bybel, Jr., Esq.
Bybel Rutledge LLP
1017 Mumma Road, Suite 302
Lemoyne, PA 17043
Facsimile: (717) 731-8205

or, as to each party, at such other address as shall be designated by such party in a written notice to the other party complying as to delivery with the terms and conditions of this Section. Such notices shall be deemed received upon actual receipt by the recipient.
 
7.4   Headings. The Section headings and other headings set forth in this Agreement are intended for purposes of convenience and reference only and shall not in any way affect the meaning or interpretation of this Agreement.
 
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7.5   Defined Terms. An index of defined terms is set forth in Attachment 4 to this Agreement.
 
7.6   Governing Law and Related Matters. 
 
(a)   Governing Law. This Agreement shall be construed in accordance with the laws of the Commonwealth of Pennsylvania (without reference to its choice of laws provisions), except to the extent that federal law is applicable.
 
(b)   Consent to Jurisdiction. Seller and Buyer each hereby agrees that any legal action or proceeding against it arising out of or relating to this Agreement or any other document or instrument executed in connection herewith, or any course of conduct, course of dealing, statement (whether oral or written), or action on the part of the other shall be brought exclusively in the court of common pleas of Montgomery County, Pennsylvania or the United States District Court for the Eastern District of Pennsylvania and, by execution and delivery hereof, Seller and Buyer each accepts and consents to, for itself and in respect of its property, generally and unconditionally, the jurisdiction of the aforesaid courts with respect to any action or proceeding brought by either of them against the other.
 
(c)   Waiver of Trial by Jury. Seller and Buyer each hereby knowingly, voluntarily and intentionally waives any and all rights it may have to a trial by jury in respect of any litigation arising out of or relating to this Agreement or any other document or instrument executed in connection herewith, or any course of conduct, course of dealing, statement (whether oral or written), or action on the part of the other. This provision is a material inducement for Seller to enter into this Agreement.
 
(d)   Waiver of Certain Damages. Seller and Buyer each hereby waives to the fullest extent permitted by law the right to assert against the other any claim for punitive, exemplary, incidental, special, indirect or consequential damages of any kind arising out of or relating to this Agreement, the Loan Purchase Agreement or any other document or instrument executed in connection herewith, or any course of conduct, course of dealing, statement (whether oral or written), or action on the part of the other.
 
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7.7   Specific Performance. Each party hereby acknowledges that monetary damages would not adequately compensate the other party in the event of a breach of this Agreement, that the non-breaching party would suffer irreparable harm in the event of any such breach, and that the non-breaching party shall have, in addition to any other rights or remedies which it may have under Section 1.7 above, the right to seek specific performance, injunctive relief or other form of equitable relief as a remedy for the enforcement hereof in the event of any such breach or threatened breach. Buyer and Seller agree that the party seeking any such form of equitable relief shall not be required to post a bond or other form of security in connection with its request for such relief.
 
7.8   Entire Agreement. This Agreement (including the Attachments, Schedules and Exhibits hereto), together with the Loan Purchase Agreement, sets forth the entire understanding of the parties hereto and supersedes any and all prior amendments, arrangements and understandings, oral or written, relating to the subject matter hereof.
 
IN WITNESS WHEREOF, this Agreement is executed the day and year first above written.
 
HARLEYSVILLE NATIONAL BANK AND TRUST COMPANY

By:                                               
     Gregg J. Wagner
     Executive Vice President
(Corporate Seal)

FIRST NATIONAL COMMUNITY BANK

By:                                                                  
  William S. Lance
(Corporate Seal)                                First Senior Vice President

-38-

 
 EX-31.1 CEO CERT 3 section302-ceocertification.htm SECTION 302 - CEO CERTIFICATION Section 302 - CEO Certification

Exhibit 31.1
CERTIFICATION

I, Demetra M. Takes , President, Chief Executive Officer and Director, certify, that:

1. I have reviewed this quarterly report on Form 10-Q of Harleysville National Corporation.

2.
Based on my knowledge, the quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)  
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)  
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)  
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)  
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonable likely to materially affect, the registrant’s internal control over financial reporting; and

5.  
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a)  
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.




Date: November 8, 2006                                                       /s/  Demetra M. Takes                            
  Demetra M. Takes
  President, Chief Executive Officer and Director
      Harleysville National Corporation

 

 EX-31.2 CFO CERT 4 section302-cfocertification.htm SECTION 302 - CFO CERTIFICATION Section 302 - CFO Certification

Exhibit 31.2

CERTIFICATION

I, George S. Rapp, Executive Vice President and Chief Financial Officer certify, that:

1. I have reviewed this quarterly report on Form 10-Q of Harleysville National Corporation.

2.
Based on my knowledge, the quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)  
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)  
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)  
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)  
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonable likely to materially affect, the registrant’s internal control over financial reporting; and

5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a)  
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.





Date: November 8, 2006                          _/s/ George S. Rapp_________________________________________
George S. Rapp
Executive Vice President and Chief Financial Officer
Harleysville National Corporation
 
 
 



 EX-32.1 CEO CERT 5 section906ceocert.htm SECTION 906 - CEO CERTIFICATION Section 906 - CEO Certification
Exhibit 32.1


HARLEYSVILLE NATIONAL CORPORATION
CERTIFICATION
PRINCIPAL EXECUTIVE OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350


In connection with the Harleysville National Corporation (the “Corporation”) Quarterly Report on Form 10-Q for the period ending September 30, 2006, as filed with the Securities and Exchange Commission (the "Report"), I, Demetra M. Takesr, President, Chief Executive Officer and Director of the Corporation, certify, pursuant to 18 U.S.C. Section 1350, as added by Section 906 of the Sarbanes-Oxley Act of 2002, that:

1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2. To my knowledge the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation as of and for the period covered by the Report.




/s/ Demetra M. Takes                         
Demetra M. Takes
President, Chief Executive Officer and Director
Harleysville National Corporation

Date: November 8, 2006
 
 




A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Harleysville National Corporation and will be retained by the Corporation and furnished to the Securities and Exchange Commission or its staff upon request.

 EX-32.2 CFO CERT 6 section906cfocertification.htm SECTION 906 - CFO CERTIFICATION Section 906 - CFO Certification

Exhibit 32.2

HARLEYSVILLE NATIONAL CORPORATION
CERTIFICATION
PRINCIPAL FINANCIAL OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350


In connection with the Harleysville National Corporation (the "Corporation") Quarterly Report on Form 10-Q for the period ending September 30, 2006, as filed with the Securities and Exchange Commission (the "Report"), I, George S. Rapp, Executive Vice President and Chief Financial Officer of the Corporation, certify, pursuant to 18 U.S.C. Section 1350, as added Section 906 of the Sarbanes-Oxley Act of 2002, that:

1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2. To my knowledge, the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation as of and for the period covered by the Report.



/s/ George S. Rapp                            
George S. Rapp
Executive Vice President and Chief Financial Officer
Harleysville National Corporation

Date: November 8, 2006




A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Harleysville National Corporation and will be retained by the Corporation and furnished to the Securities and Exchange Commission or its staff upon request.
 


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